When is calculating discounted cash flow useful?
If you are a business trying to decide whether to acquire another company or buy securities, then calculating discounted cash flow could be a useful valuation method for you. It can also be useful if you are looking to make decisions regarding operating expenditures, or capital budgeting. Learning how to invest can be a great way to grow your business.
How does DCF work?
DCF involves working out how much money you are likely to receive from an investment in the future while considering the time value of money.
Time value of money
We will now focus on the time value of money, as it is a crucial component of discounted cash flow. Essentially, this is the idea that any money you currently have is worth more than what the same quantity will be in the future, since you can invest it.
Let’s look at an example using annual interest. Imagine that you have put some money in a savings account with a 5% annual interest rate. This means that if you put £100 into this savings account, you will make 5% on this sum each year.
So, in this example, you will have £105 by the end of the year. However, if you have £100, and you don’t invest this in your savings account, you can consider its present value to be at £95, since it’s not going to earn any interest.
Present value of future cash flows
The idea of present value is therefore a very useful concept to investors looking to calculate expected cash flows. When you conduct discounted cash flow analysis, you use a discount rate in order to find the present value of your future cash flows.
If the value you calculate is higher than the current purchasing price of the investment, this means that it’s an opportunity probably worth considering. On the flip side, if the value is lower than the current purchasing price, then it might be better not to invest in the opportunity. If you are still interested, it might be best to further research it or conduct further analysis.
Weighted average cost of capital
During your analysis, you are likely to refer to your company’s weighted average cost of capital, or WACC for your discount rate. This includes the average rate of return that your shareholders are expecting for the year in question.
Why is an accurate estimate of future cash flows important?
Please note that the more accurate the estimate, the more likely it is that your investment will pay off. If you estimate future cash flows at too high a rate, then this might pay off. However, the reverse is sometimes true, in that if you estimate future cash flows at too low a rate, you might miss a fantastic opportunity to invest.
What other considerations are made during a discounted cash flow analysis?
A DCF analysis involves not only calculating future cash flow estimates, but also taking into consideration other factors such as any additional assets, ending value of the investment, and equipment. You will also need to decide on a discount rate, which might be influenced by factors like the risk profile of the investor or investment, and conditions of capital markets.
When could it be best not to use DCF analysis?
If calculating future cash flow turns out to be too complex, or cannot be estimated, it may be best to turn to other methods.
What is the formula for discounted cash flow?
The formula for calculating discounted cash flow is as follows:
Key:
DCF = discounted cash flow
CF = cash flow period
r = interest rate
n = time in years before instance of future cash flow occurs
Once you’ve added up all of your discounted cash flows (after applying your discount rate to each year), you reach a total value. Subtract the initial investment cost from the value, and you’ll get what’s known as the net present value (NPV), which is either positive or negative.
If the NPV is positive, this means it could be a worthwhile investment – as you are more likely to see a positive return. Remember the time value of money principle – you can see whether the money you have now might be worth more or less in the future based on your calculation.
Calculating discounted cash flow
Let’s break down calculating DCF into three main steps for ease:
- Forecast your expected cash flow;
- Decide on a discount rate for the investment;
- Apply the discount rate to your forecasted cash flows back to the present day – you can use a manual equation for this, or use a financial calculator.
Advantages vs disadvantages of using discounted cash flow analysis
Whether discounted cash flow analysis is right for you will depend on your specific needs as a business, particularly if you’re looking to make estimates. In this next section, we’ll look at the advantages and disadvantages of using this method.
Advantages of using discounted cash flow analysis
The core reason for using DCF analysis is that it can provide you with an estimate of future cash flows from investments. It can be applied to a wide range of different types of investment, and so is useful when it’s possible to calculate an accurate figure for future cash flows.
Another benefit of this method is that projections can be altered to reflect different future scenarios. By gaining multiple projections of future cash flows, you can fine-tune your estimate.
Disadvantages of using discounted cash flow analysis
Because you’re only creating an estimate using DCF, you might consider this to be its main weakness. If you’re finding it difficult to generate a solid estimate using DCF analysis, then this might not be the right method in this case, and you might have to use a different type of analysis instead.
Secondly, external factors such as changing market demands, changes to the economy, inflation, geopolitical tension, and other unseen influences can affect your investment’s future cash flows. As these can’t be quantified with ease, this is a consideration that is useful for investors to make when deciding on an opportunity.
Known factors as well are also worth considering when making an investment, that is, even if you have calculated a solid estimate. Other additional methods such as looking at precedent transactions as well as comparable company analysis might help you to finalise your decision.
Discounted cash flow can be a useful way of estimating whether you can expect a return on an investment in the future. It’s a flexible method that’s applicable to many different types of investment, however, it might not be appropriate in all situations. That’s because external factors can impact your future returns on investments, such as the economy or changing market plans.
Please remember that discounted cash flow analysis provides an estimate. The more solid the estimate, the more likely it is to be an accurate picture of whether an opportunity is worth investing in or not.
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