Understand the concept of the Discounted Cash Flow in Detail

Introduction to Discounted Cash Flow

Discounted Cash Flow, also known as the DCF, is a valuation method that gives the estimation of the value of an investment by using the expected future cash flows. This method of valuation is usually used by investors to determine the value of an investment today and their assumption is based upon the projections as to how much money that investment will generate. 

Discounted Cash Flow helps investors in taking into consideration whether to buy securities or acquire a company. It also assists the business managers and the owners to make the decisions related to the operating expenditures and the capital budgeting.

If, in case, the Discounted Cash Flow is higher than the current cost of the investment, then it is expected that the opportunity can result in positive returns. Companies generally use the Weighted Average Cost of Capital for arriving at the discount rate as it takes into account the rate of the expected return by the shareholders. 

What are the Advantages of the Discounted Cash Flow? 

• Evaluation of the Investment: As we have discussed the concept of the discounted cash flow in the previous sections of this article, the method of the Discounted Cash Flow allows the companies and the investors a reasonable projection as to whether the proposed investment is worthwhile or not. 

• Widely Applicable: This method of the Discounted Cash Flow is applicable to capital projects and a variety of investments where the estimation of the cash flows can be easily accessed. 

• Making of the Adjustments: This method of the Discounted Cash Flow can be tweaked in different scenarios for providing different results. This also allows the users to account for the different perspectives that are possible for the investment. 

What are the Disadvantages of the Discounted Cash Flow? 

• Involvement of the Estimates: The biggest limitation of this method is that it only involves the estimates but not the actual figures. Therefore, DCF, in order to be useful, is required to get the estimated discount rate and the cash flows. 

• Unforeseeable Economic Conditions: Due to the presence of the unenforceable Economic conditions such as the change in the economy, market demand, competition, technology, threats and opportunities, all these cannot be quantified in the exact terms and this is why investors must understand this drawback of the method.

• Not to be used in Isolation: This DCF method can never be used in isolation and this method cannot be relied upon only by the estimates. This is why it is extremely important that the investors must consider the other factors while seizing upon the opportunities. 

What is the Strength of the Discounted Cash Flow? 

• Reflects the Financial Performance: This approach is known as the intrinsic approach, which is based on the data that reflects the actual financial performance of the company. 

• Consideration of the different Multiples: This method allows the experts to consider different multiple scenarios related to the financial performance in which different possible futures can be compared based on the different assumptions. 

• Incorporation of the Financial Metrics: As this method relies upon the data from the cash flow, it incorporates a vast range of the financial metrics such as the capital expenditure, net worth and the working capital. 

The Reason behind calling this doctrine the Discounted Cash Flow

For understanding the logic behind the reason of calling this method as the Discounted Cash Flow. Let’s assume the company that is being valued is going to operate for 3 years and then stop operating. Now, the question arises regarding its worth.

The answer to this question can simply be the cash flows it produces each of the 3 years. Let’s assume that it has earned Rs. 10 crore for each year and for 3 years it has earned Rs. 30 crores. 

However, this approach is incorrect as the predicted cash flow of Rs. 10 crore in the future is not equal to Rs. 10 crore in the pocket of the company at present.  Therefore, the money at present in the hands of the company is more than the money in the future and this approach is known as the Time Value of the Money. 

In order to arrive at the true valuation of the company, it is imperative to discount the money to be received in the future. Now, the Question arises as to how we can discount the cash flow. So, let’s move ahead to understanding it in detail. 

What is the Formula for the Discounted Cash Flow? 

The Formula for the DCF is: 

DCF = CF1/(1 + r)1 + CF2 / (1 + r)2 + CFn / (1 + r) n 

Where:

CF1 = The Cash Flow for one year

CF2= The Cash Flow for year two 

CFn = The Cash Flow for the additional years 

r = The Discount Rate 

Fundamental Steps in the Discounted Cash Flow 

As we have already defined in the preceding section of this blog, deducting the discounts is a must. After deducting all the discounts, all the years are required to be added together with the factors so applied. 

The equation would look like this: 

1/ (1 + r ) ^ n

 Where 

r stands for the Discount Rate 

n stands for the number of discount years 

By looking at the above calculation, it can be understood that this calculation provides a discount facto,r which lets us know as to how much we should be investing today in order to get the figure of Rs.10 crore in the first year, Rs. 10 crore in the second year, and Rs. 1 crore in the third year. 

What happens if a Row has been added to the Discount Factor?

In this part, we will be discussing how we can get the interest from an alternative investment, which is also known as the Market Rate. Let’s assume it is 10%, which stands for r.

For First Year 

Cash Flow = Rs. 10 crore 

Discount Factor (r being 10%) = 0.9 

For Second Year 

Cash Flow = Rs. 10 crore 

Discount Factor (r being 10%) = 0.83

For Third Year 

Cash Flow = Rs. 10 crore 

Discount Factor (r being 10%) = 0.75

This means every year we discount it by using a different factorand further in the future if we use more discount the lower the discount factor we will get. 

Lastly, the cash flow each year by the discount factor is obtained. 

Then we will be getting 

For First Year 

Cash Flow = Rs. 10 crore 

Discount Factor (r being 10%) = 0.9 

Discount Cash Flow = Rs. 9 crore 

For Second Year 

Cash Flow = Rs. 10 crore 

Discount Factor (r being 10%) = 0.83

Discount Cash Flow = Rs. 8.3 crore 

For Third Year 

Cash Flow = Rs. 10 crore 

Discount Factor (r being 10%) = 0.75

Discount Cash Flow = Rs. 7.5 crore 

If you add these figures, we will get Rs. 24.8 crores, which is less than Rs. 30 crores after three years. 

Therefore, in order to remove the above ambiguity, the addition of the Terminal Value to the above figures is a must. Let’s understand how it works. 

Terminal Value 

Apart from the above ambiguity, there are other questions also which were not answered in the preceding parts and these are:

• How many years will the Company last?
• Present Value of the Cash Flow across all the upcoming years 

To answer all the above questions, the DCF method uses the Terminal Value, which represents the worth beyond the capacity of the business after 3, 5, 10, and so on years. 

Calculation of the Terminal Value 

Calculation of the Terminal Value is based on the below-mentioned formula. This formula is popularly known as the Gordon Growth Formula. 

FCFn * (1 + g)/ (d – g)

FCFn stands for the Free Cash Flow in a year

N stands for the last forecasted period

G stands for the Terminal Growth Rate

D stands for the discount rate 

Now, let’s assume that the Terminal Growth Rate is 1.7% 

If we put this in the above-mentioned calculation and it gives us Rs. 98.7 crores as the forecasted value. Lastly, using the WACC of 12% in the third year provides a discount rate of 0.75, which gives the Net Present Value of the Terminal Value to be Rs. 74 crore. 

What are the two Methods of calculating the Terminal Value?

The two major methods of calculating the Terminal Value are:

• By using the Gordon Growth Method (which has already been discussed in the above example)
• By assuming the business is sold at that point: This approach is also called the multiple-based approach as experts assume that the business is sold as the multiple of some financial metrics. 

How to Calculate the Discounted Cash Flow? 

• Forecasting the Expected Cash Flow: The first step in the process is to forecast the expected cash flow in the future from the investments. 

• Selecting the Rate of Discount: The next step in the process is to select the rate of the discount, which is based upon the cost of financing the investment or the cost of the opportunity presented by the alternative investments

• Discounting the Cash Flow: The last step in the process is to discount the cash flow back to the present day by using the financial calculator, manual calculation, or the spreadsheet. 

• Obtaining the NPV: As the last step of the DCF, all the above figures are required to be added up in order to obtain the NPV. 

Is the Concept of the Discounted Cash Flow the same as that of the Net Present Value (NPV)? 

The Concept of the Discounted Cash Flow and the Net Present Value are one and the same, but they are closely related to each other. The difference between them is that NPV adds a fourth step to the calculation of the DCF.

After the completion of the forecasted expected flow selecting a discount rate, discounting those cash flows and then summing them up and lastly NPV deducts the cost of the investment from the DCF. 

What is an Example of the Discounted Cash Flow?

When a company is involved in the process of analysing whether it should invest in the purchase of new equipment or invest in a certain project, the company uses the Weighted Average Cost of Capital (WACC) as the discount rate to evaluate the DCF. 

WACC incorporates the average rate of the return that the company shareholders expect for the year. 

For instance: If a company wants to launch a new project and the WACC of the company is 5%, this means that the discount rate will also be 5%. If the initial investment is Rs 11 million and the project lasts for a period of 5 years with the below-mentioned cash flows per year: 

Cash Flow

Year	Cash Flow
1	Rs. 1 million
2	Rs. 1 million
3	Rs. 4 million
4	Rs. 4 million
5	Rs. 6 million

By using the Discounted Cash Flow, these calculated discounted cash flows for the project are as follows:

Discounted Cash Flow  

Year	Cash Flow	Discounted Cash Flow
1	Rs. 1 million	Rs. 952,381
2	Rs. 1 million	Rs. 907, 029
3	Rs. 4 million	Rs. 3,455,350
4	Rs. 4 million	Rs. 3,290,810
5	Rs. 6 million	Rs. 4,701,157

Adding all these discounted cash flows results in a value of Rs. 13, 306, 727 and by diminishing the initial investment of Rs. 11 million from this value, an NPV of Rs. 2,306,727 can be obtained. This positive figure indicates that the project can generate a higher return than the initial costs and this can be summed up that the project is worth investment. 

On the other hand, if the project cost Rs. 14 million and the NPV would have been Rs. 693,272, which indicates that the cost of the project is more than its projected return, and it’s not worth making the investment.  

What are the reasons for using the Discounted Cash Flow Model?

• Helpful in the Valuation: The DCF model helps in the valuation of the business, which helps in selling or purchasing the business. 

• Project Valuation: As we have already discussed in the example, with the help of this model, the projects can be valued in a greater sense. 

• Valuation of the Stocks: This reason is also an extended reason of the above, which helps in understanding and comparing the prices of the stocks to the actual price in order to decide whether to invest in the stock or not. 

• Raising Capital: We are very well aware that the DCF model is a type of valuation model that helps in the valuation of the company and thereby giving the required edge to the company as to how much capital they are required and helps in attracting the investors as well. 

• Impacting the Initiative: The DCF method helps in assessing the impact of the initiative, such as the cost-saving programme or the entering of a new market. 

• Internal Use: The DCF Model helps in the internal financial planning and use of the company, such as the Internal Financial Planning and Accounting Purposes, budgeting, and forecasting. 

The Different Models of the Discounted Cash Flow

• DCF WACC: This is the simplified version of the DCF in which the Free Cash Flow to the organisation is calculated and then these cash flows are discounted by using the WACC as the discount by keeping the constant capital structure during the forecasted period. 

• DCF WACC: This method is similar to the above method, which calculates a different WACC in each of the forecasted periods based upon the changing capital structure and changing the beta in every period. 

• Flow to Equity: In this method, the Free Cash Flow to Equity is calculated and the discounting of these cash flows is done by using the Cost of the Equity. 

Conclusion 

Discounted Cash Flow is the approach that is used widely by experts and it is also known as the most common approach for this reason. With the help of this method, the future cash flows of the company can be obtained by using the discount rate. The Discounted Cash Flow approach helps the business in understanding whether an investment or project is worth investing in or not.

Frequently Asked Questions on Discounted Cash Flow

Q1. What is a discounted cash flow?

Ans 1. Discounted Cash Flow is a method of valuation of the investments that produce the cash flow. 

Q2. What is the difference between NPV and DCF?

Ans 2. NPV and DCF are the same valuation methodologies. 

Q3. What is another name for DCF?

Ans3. DCF stands for the discounted cash flow and the other name for it is Net Present Value (NPV)

Q4. Is DCF and IRR the same?

Ans4. No, DCF and IRR are different.

Q5. Why is DCF not used for banks?

Ans5. DCF is considered less favourable for the banks due to the fact that their cash flows are complex and also influenced by other regulatory factors. 

Q6. What are the two types of DCF?

Ans6. The two types of the DCF models are the Free Cash Flow to Equity and the Free Cash Flow to Firm Model. 

Q7. Why DCF is not used for startups?

Ans7. The main reason that DCF is not used for startups is due to the fact that the historical data to project the cash flows in a startup is not available. 

Q8. What is the principle of DCF?

Ans8. This principle method takes into account the value of the company to be equal to the future cash flows of the company discounted to the present value by using the appropriate discount rate. 

Q9. What is the formula for the cost of equity?

Ans9. The formula for the cost of the Equity = Risk – Free Rate of Return + Beta * (Market Rate of Return – Risk Free Rate of Return)

Q10. Is EBITDA used in DCF?

Ans10. Yes, DCF uses a series of factors, which also includes the EBITDA, for arriving at the future value of the investment.