Discount Cash Flow
The Discounted Cash Flow (DCF) analysis is the the Net Present Value (NPV) of projected cash flows. The concept of DCF valuation is based on the principle that the value of a business or asset is based on its ability to generate cash flows for investors. To that extent, the DCF relies more on the fundamental expectations of the business than on public market factors or historical precedents, and it is a more theoretical approach relying on a number of assumptions. A DCF analysis is about determining the overall value of a project when considering both debt and equity. The consideration of debt and equity is borne out by the Weighted Average Cost of Capital (WACC) which is usually used in the DCF as the rate of return or hurdle rate.
The DCF analysis takes into consideration future cash flows and discounts them to today's dollars which is used to evaluate a potential project.
The following is the equation;
DCF=Future Value X (1+r)-n
Which translates to;
Future Value (FV) is the amount you will receive at a point in time.
r is the annual rate of return.
n is the number of periods in the above years.
Present Value is the result of the above equation.
So lets start with a simple example. I give my parents $1000 today and I estimate the WACC rate to be 7% and I will receive exactly $1,000 in 5 years time as my father does not appreciate the concept of the time value of money.
Using the above equation we can determine the value in 5 years time of the $1000.
DCF=$1000 X (1.07)^-5
So my assumptions have told us that the $1000 I receive in 5 years time will be the same as having $713 today (based on my 7% assumption) . Not the best result but what are you going to do?
Discounted cash flow model is a powerful method but it does have disadvantages. DCF is merely a valuation tool, which makes it highly subjective to the underlying assumptions.
However, the calculation of the discounted cash flow can help investors avoid committing to investments that are less likely to help them achieve their goals. It identifies investments that demonstrate a high level of potential to aid them in reaching the desired results.