What Is Discounted Cash Flow? Example, Formula And Methods

Discounted Cash Flow: Have you ever wondered how investors predict the true value of an investment today based on its future earnings? This is where Discounted Cash Flow (DCF) comes in—a powerful tool to estimate the present value of future cash flows.

By using the discounted cash flow method, investors apply a discount rate to bring expected earnings back to today’s terms. Discounted cash flow analysis helps evaluate the worth of companies, projects, or securities with precision. With the help of a clear discounted cash flow formula, it offers a structured approach to making sound financial decisions.

In this guide, we’ll explore everything from what is discounted cash flow to its formula, calculation, types, and the pros and cons of using DCF.

Table of Contents

What is Discounted Cash Flow?

Discounted Cash Flow (DCF) is a method used to estimate the present value of an investment by predicting its future cash flows. It’s based on the idea that money today is worth more than money in the future due to the time value of money (TVM).

For example, if an investment is expected to generate ₹10 lakh annually for the next five years, DCF uses a discount rate to calculate what those future amounts are worth today.

This method helps investors, analysts, and business owners assess the value of companies, projects, or securities. By factoring in the risks and required returns, DCF analysis serves as a dependable tool for evaluating investments and making informed financial decisions.

Discounted Cash Flow Analysis

Discounted Cash Flow analysis evaluates whether an investment is worth pursuing by estimating its future returns and adjusting for the time value of money. If the DCF value exceeds the initial investment cost, the project is considered profitable.

For instance, an investment with a higher DCF indicates better returns, while a lower DCF suggests holding onto the cash might be wiser.

To conduct a discounted cash flow analysis, first predict the cash flows for a specific period and estimate the investment’s terminal value. Then, discount these values to their present worth using an appropriate rate, like the cost of capital or Weighted Average Cost of Capital (WACC), depending on the investment’s financing.

Also Read: Cash Flow from Financing Activities

Discounted Cash Flow Formula

The Discounted Cash Flow Formula helps determine the present value of an investment by adjusting future cash flows for the time value of money. Here, check the discounted cash flow formula:

Discounted Cash Flow Formula

Where:

CF₁, CF₂, CFₙ = Cash flows for each period (e.g., year 1, year 2, etc.)
r = Discount rate or required rate of return
n = The number of years until each cash flow occurs

This formula helps determine if the value of an investment today justifies its future earnings.

Step-by-step Guide to Calculate Discounted Cash Flow

Calculating Discounted Cash Flow (DCF) involves a few simple steps. Here’s a simple guide to follow:

Step 1: Estimate Future Cash Flows

Project the future cash flows (free cash flow) that the investment is likely to generate.

Step 2: Determine the Discount Rate

Choose an appropriate discount rate, often using the Weighted Average Cost of Capital (WACC), to account for the time value of money.

Step 3: Calculate Terminal Value

Estimate the investment’s value at the end of the forecast period.

Step 4: Discount the Cash Flows and Terminal Value

Apply the discount rate to the cash flows and terminal value to bring them to their present value.

Step 5: Sum the Values

To calculate the Net Present Value (NPV), you need to sum the present values of the cash flows and the terminal value. This total reflects the overall value of the investment.

These steps can be done manually or with the help of tools like Excel or Valutico for faster calculations.

Discounted Cash Flow Example

Let’s consider an example where a company evaluates the potential of investing in a new piece of machinery. The company applies the Discounted Cash Flow method to assess whether the investment is valuable. For this case, the Weighted Average Cost of Capital (WACC) is 8%, which will be used as the discount rate.

Project Details:

Initial Investment: ₹20 million
Project Duration: 5 years
WACC (Discount Rate): 8%

Estimated Cash Flows:

Discounted Cash Flow Example
Year	Cash Flow (₹)
1	₹3 million
2	₹4 million
3	₹5 million
4	₹6 million
5	₹7 million

Discounted Cash Flow Calculation:

Using the Discounted Cash Flow Formula, we calculate the discounted value for each year as follows:

Year	Cash Flow (₹)	Discounted Cash Flow (₹)
1	₹3 million	₹2,777,778
2	₹4 million	₹3,428,571
3	₹5 million	₹3,937,008
4	₹6 million	₹4,343,370
5	₹7 million	₹4,731,067

Net Present Value (NPV):

To calculate the Net Present Value (NPV), we sum the discounted cash flows:

Total Discounted Cash Flow = ₹19,217,794
Initial Investment = ₹20 million
NPV = ₹19,217,794 – ₹20,000,000 = -₹782,206

Since the NPV is negative (-₹782,206), it indicates that the project would not generate enough return to cover the initial cost. In this case, it would be advisable for the company to reconsider the investment.

Different Types of Discounted Cash Flow Methods

Discounted Cash Flow analysis can be performed using different methods, each suited to specific investment scenarios. The main difference lies in how the cash flows are calculated and the discount rates applied. Here are the most widely used types of discounted cash flow methods:

DCF WACC Method: Uses Free Cash Flow to Firm (FCFF) and discounts with a constant Weighted Average Cost of Capital (WACC). Best for stable capital structures.
DCF WACC with Changing Capital Structure: Similar to the DCF WACC, but updates the WACC for changes in the debt-to-equity ratio. Ideal for projects with evolving capital structures.
Flow to Equity (FTE) Method: This method focuses on Free Cash Flow to Equity (FCFE) and applies the cost of equity as the discount rate. Best for equity-focused investments.
Adjusted Present Value (APV) Method: Separates the project’s operating value and financing effects, adding tax shields. Suitable for leveraged buyouts (LBOs) or projects with changing financing.
Capital Asset Pricing Model (CAPM): A method to determine the discount rate, considering the risk-free rate, investment beta, and market return. Used to calculate the required rate of return in DCF.

Each of these methods can produce a similar valuation, but the choice of method depends on the type of project, the available data, and the investor’s preferences.

Also Read: What is Cost Accounting? Definition, Types and Advantages

Pros & Cons of Discounted Cash Flow

Discounted Cash Flow analysis is a popular technique for assessing investments by considering their projected future cash flows while accounting for the time value of money. Like any financial tool, DCF has both benefits and limitations, which are important to consider when using the discounted cash flow formula.

Pros of DCF Analysis

Versatile Application: The discounted cash flow method can be used for a variety of investments, from companies to capital projects, as long as future cash flows can be estimated.
Considers Future Cash Flows: DCF focuses on projected cash flows, providing a forward-looking perspective that helps investors make informed decisions.
Scenario Adjustments: It allows for adjusting estimates and testing different scenarios to understand how changes in assumptions impact investment returns.
Time Value of Money: DCF accounts for the time value of money, ensuring that future cash flows are discounted to reflect their value today, offering a more accurate valuation than methods that don’t.
Detailed Approach: The discounted cash flow formula offers a detailed, structured approach to valuation, offering deeper insights into the financial viability of an investment.

Cons of DCF Analysis

Depends on Estimates: DCF relies heavily on estimates (like future cash flows and discount rates), meaning the result is also an estimate and may not be accurate.
Sensitive to Assumptions: The accuracy of discounted cash flow analysis can be significantly affected by assumptions. Minor changes in assumptions can cause significant differences in the results.
Time-Consuming: Performing a DCF analysis can be complex and time-consuming, requiring detailed financial data and expertise.
Doesn’t Compare to Competitors: Unlike comparative analysis, DCF doesn’t directly compare a company to its competitors, which can be important for relative valuation.
Ignores Market Sentiment: DCF doesn’t account for current market psychology or external factors like investor sentiment, which can impact the market price of an asset.

Therefore, discounted cash flow is a powerful tool for evaluating investment opportunities but should be used alongside other methods and with careful consideration of its assumptions.

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Discounted Cash Flow FAQs

What is the meaning of discounted cash flow?

Discounted Cash Flow (DCF) is a technique used to assess the value of an investment by evaluating its anticipated future cash flows. It helps assess the current value of an investment by considering its projected future earnings.

How is DCF calculated?

The Discounted Cash Flow (DCF) formula involves adding up the cash flows for each period and dividing each by one plus the discount rate (WACC) raised to the power of the period number to calculate the present value of future cash flows.

Are DCF and NPV the same?

No, while both methods evaluate investments, Discounted Cash Flow (DCF) determines the intrinsic value by forecasting future cash flows, whereas Net Present Value (NPV) compares the present value of inflows and outflows to assess the investment's profitability.

Why is DCF so popular?

Discounted Cash Flow (DCF) is widely used because it accounts for the time value of money by discounting future cash flows to their present value. It helps investors make informed decisions about whether an investment will generate enough value relative to its cost.

What is an example of DCF?

An example of Discounted Cash Flow would involve calculating the present value of expected cash flows from a project over several years, then subtracting the initial investment cost to determine if the project is financially worthwhile.