10/16/2015 Discounted Cash Flow (DCF)

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DEFINITIONDEFINITIONDiscounted cash flow (DCF) is a valuation method used to estimate the attractiveness of an investment opportunity. DCF analysis uses Discounted cash flow (DCF) is a valuation method used to estimate the attractiveness of an investment opportunity. DCF analysis uses future freefuture free

cash flowcash flow projections and discounts them to arrive at a projections and discounts them to arrive at a present valuepresent value estimate, which is used to evaluate the potential for investment. If the value estimate, which is used to evaluate the potential for investment. If the value

arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one.arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one.

Calculated as:Calculated as:

DCF is also known as the Discounted Cash Flows Model.DCF is also known as the Discounted Cash Flows Model.

INVESTOPEDIA EXPLAINSINVESTOPEDIA EXPLAINSThere are several variations when it comes to assigning values to cash flows and the discount rate in a DCF analysis. But while the calculationsThere are several variations when it comes to assigning values to cash flows and the discount rate in a DCF analysis. But while the calculations

involved are complex, the purpose of DCF analysis is simply to estimate the money an investor would receive from an investment, adjusted for theinvolved are complex, the purpose of DCF analysis is simply to estimate the money an investor would receive from an investment, adjusted for the

time value of moneytime value of money. . 

The time value of money is the assumption that a dollar today is worth more than a dollar tomorrow. For example, assuming 5% annual interest,The time value of money is the assumption that a dollar today is worth more than a dollar tomorrow. For example, assuming 5% annual interest,

$1.00 in a savings account will be worth $1.05 in a year. Due to the symmetric property (if $1.00 in a savings account will be worth $1.05 in a year. Due to the symmetric property (if a=ba=b, then , then b=ab=a), we must consider $1.05 a year from now), we must consider $1.05 a year from now

to be worth $1.00 today. When it comes to assessing the future value of investments, it is common to use the to be worth $1.00 today. When it comes to assessing the future value of investments, it is common to use the weighted average cost of capitalweighted average cost of capital

(WACC)(WACC) as the as the discount ratediscount rate..

Discounted Cash Flow (DCF)Discounted Cash Flow (DCF)By By rootroot | Updated September 29, 2015| Updated September 29, 2015

10/16/2015 Discounted Cash Flow (DCF)

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For a hypothetical Company X, we would apply DCF analysis by first estimating the firm's future cash flow growth. We would start by determiningFor a hypothetical Company X, we would apply DCF analysis by first estimating the firm's future cash flow growth. We would start by determining

the company's trailing twelve month (ttm) the company's trailing twelve month (ttm) free cash flow (FCF)free cash flow (FCF), equal to that period's , equal to that period's operating cash flowoperating cash flow minus minus capital expenditurescapital expenditures. Say that. Say that

Company X's ttm FCF is $50 m. We would compare this figure to previous years' cash flows in order to estimate a rate of growth. It is also importantCompany X's ttm FCF is $50 m. We would compare this figure to previous years' cash flows in order to estimate a rate of growth. It is also important

to consider the source of this growth. Are sales increasing? Are costs declining? These factors will inform assessments of the growth rate'sto consider the source of this growth. Are sales increasing? Are costs declining? These factors will inform assessments of the growth rate's

sustainability. sustainability. 

Say that you estimate that Company X's cash flow will grow by 10% in the first two years, then 5% in the following three. After a few years, you maySay that you estimate that Company X's cash flow will grow by 10% in the first two years, then 5% in the following three. After a few years, you may

apply a long-term cash flow growth rate, representing an assumption of annual growth from that point on. This value should probably not exceed theapply a long-term cash flow growth rate, representing an assumption of annual growth from that point on. This value should probably not exceed the

long-term growth prospects of the overall economy by too much; we will say that Company X's is 3%. You will then calculate a WACC; say it comeslong-term growth prospects of the overall economy by too much; we will say that Company X's is 3%. You will then calculate a WACC; say it comes

out to 8%. The terminal value, or long-term valuation the company's growth approaches, is calculated using the out to 8%. The terminal value, or long-term valuation the company's growth approaches, is calculated using the Gordon Growth ModelGordon Growth Model::

Terminal value = projected cash flow for final year (1 + long-term growth rate) / (discount rate - long-term growth rate)Terminal value = projected cash flow for final year (1 + long-term growth rate) / (discount rate - long-term growth rate)

Now you can estimate the cash flow for each period, including the the terminal value:Now you can estimate the cash flow for each period, including the the terminal value:

Year 1Year 1 = 50 * 1.10= 50 * 1.10 5555

Year 2Year 2 = 55 * 1.10= 55 * 1.10 60.560.5

Year 3Year 3 = 60.5 * 1.05= 60.5 * 1.05 63.5363.53

Year 4Year 4 = 63.53 * 1.05= 63.53 * 1.05 66.7066.70

Year 5Year 5 = 66.70 * 1.05= 66.70 * 1.05 70.0470.04

Terminal valueTerminal value = 70.04 (1.03) / (0.08 - 0.03)= 70.04 (1.03) / (0.08 - 0.03) 1,442.751,442.75

Finally, to calculate Company X's discounted cash flow, you add each of these projected cash flows, adjusting them for Finally, to calculate Company X's discounted cash flow, you add each of these projected cash flows, adjusting them for present valuepresent value using the using the

WACC:WACC:

DCFDCFCompany XCompany X = (55 / 1.08 = (55 / 1.0811) + (60.5 / 1.08) + (60.5 / 1.0822) + (63.53 / 1.08) + (63.53 / 1.0833) + (66.70 / 1.08) + (66.70 / 1.0844) + (70.04 / 1.08) + (70.04 / 1.0855) + (1,442.75 / 1.08) + (1,442.75 / 1.0855) = 1231.83) = 1231.83

$1.23 b is our estimate of Company X's present $1.23 b is our estimate of Company X's present enterprise valueenterprise value. If the company has net debt, this needs to be subtracted, as equity holders' claims to. If the company has net debt, this needs to be subtracted, as equity holders' claims to

a company's assets are subordinate to bondholders'. The result is an estimate of the company's fair equity value. If we divide that by the number ofa company's assets are subordinate to bondholders'. The result is an estimate of the company's fair equity value. If we divide that by the number of

shares outstanding—say 10 m—we have a fair equity value per share of $123.18, which we can compare with the market price of the stock. If ourshares outstanding—say 10 m—we have a fair equity value per share of $123.18, which we can compare with the market price of the stock. If our

estimate is higher than the current stock price, we might consider Company X a good investment.estimate is higher than the current stock price, we might consider Company X a good investment.

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© 2015, Investopedia, LLC.© 2015, Investopedia, LLC.

Discounted cash flow models are powerful, but they are only as good as their imports. As the axiom goes, "garbage in, garbage out". Small changes inDiscounted cash flow models are powerful, but they are only as good as their imports. As the axiom goes, "garbage in, garbage out". Small changes in

inputs can result in large changes in the estimated value of a company, and every assumption has the potential to erode the estimate's accuracy.inputs can result in large changes in the estimated value of a company, and every assumption has the potential to erode the estimate's accuracy.

How to use DCF to value stock market? Read How to use DCF to value stock market? Read DCF Valuation: The Stock Market Sanity CheckDCF Valuation: The Stock Market Sanity Check and and Using DCF In Biotech ValuationUsing DCF In Biotech Valuation