A Guide to Discounted Cash Flow (With Formula and Examples)
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Discounted cash flow (DCF) is an accounting method that financial professionals use to evaluate a return on investment (ROI). Determining the DCF is important because it demonstrates whether an investment is worthwhile for a business based on its potential. Understanding how to apply this method can help you contribute to long-term business decisions that are profitable and responsible. In this article, we define DCF, provide the formula to calculate it, supply an example, detail its benefits and limitations, and explain how it applies to the workplace.
What is discounted cash flow?
Discounted cash flow (DCF) is a mathematical method that financial professionals use to approximate the value of investments. When considering an investment, accountants determine the approximate value it may bring in the future. The formula analyzes the amount of revenue that the investment can generate. Taking this approximation, it analyzes the earning potential and charts the expenses versus the revenue over time. This is important for those who oversee the long-term financial undertakings of a company, including the purchase of equipment or real estate.
DCF calculations require an understanding of several aspects of the investment. For example, the DCF function determines investment based on future flows of cash. It predicts future markets and returns versus the costs of an investment. While this approach has certain limitations, it relies on approximations, which can prove inaccurate. For this reason, most financial professionals rely on multiple analyses to make decisions on investment holdings for private and public enterprises.
Formula to calculate DCF
Calculating the DCF involves getting the sum of all cash flows for each accounting cycle. You then divide this sum by one, plus the discounted rate raised to the n exponent. Below is the formula:
DCF = [(cash flow) · (1 + r)^1] + [(cash flow) · (1 + r)^2] + [(cash flow) + (1 + r)^n]
The DCF formula includes the following three variables:
r value: This variable is the rate of discount, equal to the weighted average cost of capital (WACC). The company's WACC represents the average rate it expects to pay its stakeholders to finance its assets.
n value: This variable represents the number of periods in which the company reports. For example, if the company makes yearly reports, the n value is one for each year, so if it finances something for five years, then n equals five.
Cash flow: This refers to the liquid cash flow that a company has after it subtracts payments for operating expenses, investments, or other capital expenditures, such as inventory or maintenance.
Examples of using DCF
For an example of using a DCF, consider a company planning to purchase an apartment building as an investment. To determine its DCF rate, it considers the following information:
present investment value = $30,000
liquid cash flow = $500,000
projected ROI = $1,000,000
discount rate = 20%
The company aims to measure the DCF rate over a period of five years, meaning it has an n-value of five, an r-value of 0.20, and a cash flow value of $500,000. The DCF formula is as follows:
DCF = [(cash flow) · (1 + r)^1] + [(cash flow) · (1 + r)^2] + [(cash flow) + (1 + r)^n] =
[($500,000) · (1 + 0.20)^1] + [($500,000) · (1 + 0.20)^2] + [($500,000) · (1 + 0.20)^3] + [($500,000) · (1 + 0.20)^4] + [($500,000) · (1 + 0.20)^5]**=**
($416,667) + ($347,222) + ($289,351) + ($241,126) + ($200,938) = $1,495,304
The DCF shows that the company can expect the investment to return well over the initial $1,000,000 investment within five years. The numbers show that the company gains a cash flow value of $495,304 by the time its investment matures. As it's likely to be profitable, the company can choose to proceed with the investment.
Benefits and limitations of DCF
Approaching business investment decisions using the DCF method has advantages and limitations. Its efficiency and accuracy can depend on what you're using it to determine. For example, if you aim to approximate the future value of a volatile stock purchase, the lack of predictability makes DCF calculations less accurate. Conversely, using the DCF to calculate the investment potential of equipment purchases can be accurate as you can easily track the value over time. Here are some other advantages and limitations of DCF:
The DCF enables you to estimate whether an investment is going to have a sufficient return. When making long-term financial decisions, this provides an advantageous understanding of detailed cash flow. It shows the value an organization offers, in terms of both potential and current value. The DCF formula offers insight into the future, allowing companies to make informed presentations to stakeholders. It also enables them to determine the internal rate of return. Ultimately, it provides an opportunity for companies to analyze their overall interests.
DCF calculations aren't always appropriate, and if you use them incorrectly, they can result in issues with accuracy. For example, future earnings aren't a guarantee. The DCF is a projection that relies on various external factors. It can be accurate at the time you calculate it, yet the formula requires you to assume facts about the future. The complexity of cash flow analysis can result in unforeseen fluctuations.
How to calculate the DCF
Finance professionals, such as investment bankers and accountants, rely on DCF analyses to assess whether investing in something is reasonable. The DCF assesses whether a company might receive sufficient long-term benefits from the investment. The following are steps for calculating the DCF:
1. Perform a cash flow analysis
Calculating the DCF involves considering the company's actual cash flow and understanding the nature of the investment. It estimates what the investment could be worth in the future while considering the time value of money. Over time, the value of an investment ought to be higher than its current value. Time adds value to the money, growing the investment.
The DCF provides you with the current value of expected cash flow in the future. For example, if you have six dollars now, that investment ought to be worth more as time passes. In some dealings, the DCF might indicate a return of three dollars. In other situations, it could yield only an extra 25 cents. These results show whether it's profitable and reasonable to make the investment.
2. Conduct a future value estimation
The estimated future value determines the future value of your investment. For example, if a company plans to acquire a new asset, it determines the future cash flows that result from this purchase. These estimates determine the actual value of the investment and whether it's worth making. When making a future estimate, companies consider aspects like equipment, real estate holdings, and financial assets like stocks. Companies also consider depreciation when calculating future earnings. A company may see a large return from a machinery investment, though the value depreciates because of normal wear and tear.
3. Make a discount rate assessment
The discount rate is perhaps the most important component of the DCF calculation. A company identifies a suitable value for this rate in situations where it can't use a WACC. The discount rate is variable in many cases. It depends on factors such as the company's risk profile and the present conditions of capital markets. Socioeconomic and political considerations also impact the discount rate. In situations where a company can't access a WACC or find a reasonable discount rate, a different formula is likely to be more appropriate.
4. Use the DCF formula
The aim of the DCF formula is to determine the estimate for future cash flow channels. You can use these values by entering them into the DCF formula and determining the result. Before determining the DCF, businesses usually determine a desired outcome. If the prospective threshold meets these requirements, a business is likely to proceed with the investment. Conversely, if the ROI is lower than it expects, the company can consider other options.
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