There is no surefire way to estimate the future value of an investment, but the formula to determine expected future cash flow (both incoming and outgoing) is one of the more reliable methods. The discounted cash flow method, often abbreviated as DCF, is an analysis method that calculates how much money an investment will generate in the future based on the current value. It is important data for the decision makers in companies that plan on investing in, merging with or acquiring other companies — or even making capital investments in their own companies.
What Is Discounted Cash Flow?
So, what is DCF modeling? It uses a series of factors, including EBITDA (or earnings), in order to arrive at the future value of the investment. In most instances, the DCF valuation method is used when valuing privately held companies; however, in some cases, it’s used in publicly held companies that issue stock. In short, the DCF method is a way of estimating how much cash flow at a certain time in the future will be a result of today’s investment.
How Is DCF Calculated?
The formula for calculating DCF is a complex one. A standard DCF model takes the sum of the cash flow (in each period) into account and divides that by one plus the discount rate (WACC) raised to the power of the period number. Not a simple process by any means, and there are several factors to be aware of. These include cash flow (CF), discount rate (r) and period number (n) to arrive at a DCF valuation.
Practical Uses of DCF
As mentioned earlier, decision-makers typically use DCF analysis to estimate the future cash flow of an investment.
- After all future cash flows are estimated, they’re discounted by using the cost of capital to give their present values (PVs).
- The total of future cash flows (which includes both incoming and outgoing cash flow) determines the net present value (NPV), which takes the input cash flows and applies a discount
- This determines the number of discounted cash flow.
You can learn more about the use cases of DCF, as well as the pros and cons of this technique here.
How DCF Reacts to Unexpected Change
The discounted cash flow analysis is more of an art than a science. While the formula for it has variables, some changes can’t be factored into the equation. A number of inherent issues may affect earnings and cash flow, which are usually predicted for five or 10 years in advance. The unexpected changes that can wreak havoc with the DCF method include:
Estimating Operating Cash Flow Projections
Projected cash flow becomes more nebulous the further out it goes. Cash flow projections for one or two years (and possibly three years) will most likely prove fairly accurate, but after that, it’s the great unknown and each successive year has a larger chance to be less and less accurate. World events, financial crises and other unavoidable issues certainly have the ability to interfere with assumptions.
Capital Expenditures Projections
Capital expenditure is rarely projected out too far in the future, and the assumptions made can prove to be quite risky, so more uncertainty surrounds this issue. In addition, where a capital expenditure is concerned even small changes in the assumption can greatly affect the results of your DCF calculations.
Differences in Discount Rate and Growth Rate Assumptions
There are different methods (such as the Markowitz formula or the weighted average cost of capital) to approach the discount rate in a DCF model. While there is no “right or wrong” way to approach things, all of these growth rate assumption methods are dependent on the rates holding steady in perpetuity, which is highly unlikely.
DCF vs. Other Valuation Formulas
While discounted cash flow models remain a popular way to predict cash flow and valuation, there are other approaches to valuing a business or asset in the future. These include:
Comparable Analysis (aka Comps)
This is a valuation method that compares your business to other, similar businesses. It uses data such as P/E, EV/EBITDA and other factors, and is probably the simplest method to provide a valuation. In the real estate industry, comps determine the valuation of properties.
Precedent Transactions
Similar to comps, this method compares one company to others, specifically to companies in the same industry that have been acquired or sold. (The transaction values include the take-over premium in the acquisition price.) The downside of precedent transactions is that you need recent valuations, as data from the past is no longer relevant.
One More Thing
No matter which method you use for estimating the future cash flow of a business, having a trusted enterprise document management and virtual data room (VDR) partner is one of the ingredients for success. A VDR is a secure, online space where all parties involved in the transaction can store, share and edit all documentation involved with the deal.
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Chris Capelle is a technology expert, writer and instructor. For over 25 years, he has worked in the publishing, advertising and consumer products industries.
