The discounted cash flow (DCF) is a method of valuation or a fundamental analysis equation that is used to calculate the future cash flows for investments to get their present value. DCF is most often used by investors to calculate the time value of money and returns that they are to get out of an investment. Here, future cash flows are first calculated by estimation and then are discounted to give the present values. This discount rate represents the cost of capital and also the risk involved in the future cash flows. DCF is a necessary calculation in investment finance, real estate development, and corporate financial management.
DCF can be calculated by the following formula:
DPV = FV/(1+i)n = FV(1-d)n
Here, DPV is the discounted present value for the future cash flow, FV represents the future value of the cash flow, it is the interest rate for cash used for the investment, n represents the number of years until the new cash flow comes into picture, and d is the discounted rate assumed at the beginning of the year.
DCF does not depend on the amount of investment made, but on what are the returns on that investment. For example, even a smaller investment in real estate may yield a higher return than a much bigger investment. Thus, DCF is a very critical analysis when a company is assessing different investment projects and has to prioritize on the most profitable one.
History suggests that DCF came into being when money was first lent at interest in ancient times. DCF is quite different from accounting book value as it is not based on the amount paid for the asset. Since the stock market crash of 1929, DCF was popularized as a method of valuation.
There are various different DCF methods that can be used for valuation depending on the capital structure of a company. They are also known as the discounted future economic income methods.
1. Flows to equity (FTE)
Here, the cash flows to the holder of equity capital are discounted after subtracting the debt capital. Though it is advantageous in certain cases, it still requires good judgment on the discount rate.
2. Adjusted present value (APV)
Here, the cash flows are discounted without subtracting the debt capital, but the tax relief on the debt capital. It requires a simpler calculation over FTE.
3. Weighted average cost of capital (WACC)
Here, a weighted cost of the capital is got from different sources and that is used to discount the cash flows.
Thus, DCF can be used to determine the value of various business ownerships like equity or debt holders.
Also, this can be used to value the company.
However, DCF is not free from criticism. It is thought to be a mechanical valuation tool as even minimal changes in the values can result in huge difference in the valuation for a company, which may sometimes make a great difference. Sometimes terminal value techniques are used, as it becomes hard to have realistic estimates of cash flows for DCF as time goes on.