Discounted Cash Flow Analysis (DCF)

The Discounted Cash Flow (DCF) analysis, along with the multiples method and the income approach, is one of the three most important valuation methods in the world of finance. It helps finance professionals and investors estimate the true worth of a company based on its underlying business and future potential, rather than just its current price on the stock market. The gap between the DCF value and the investment price helps to decide if the opportunity is a good deal. Let’s explore what DCF entails below. 
 

What Is Discounted Cash Flow Analysis? 

Discounted Cash Flow (DCF) analysis is a valuation method. It helps analysts estimate how much an investment or a company is worth today based on how much money it's expected to make in the future. It's widely used in finance, investment banking, and business valuation.

DCF accounts for the fact that money today is worth more than the same amount of money in the future due to:

• Time value of money (opportunity cost)
• Risk and uncertainty
• Inflation
   

How Does DCF Work?

DCF works in four primary steps: 

The total value is then compared to the current market price to assess whether the investment is undervalued or overvalued.

Let’s go over each of these steps in detail below. 

1. Forecast Future Cash Flows

The first step in DCF analysis is forecasting the cash a company is expected to generate over a specific period, typically 5 to 10 years. It’s a very important step because the usefulness or accuracy of the valuation is highly sensitive to these projections. 

Analysts use historical data, industry trends, and assumptions about future performance. They make assumptions about factors like sales growth, operating margins, and capital expenditures to estimate these future cash flows. 

2. Determine a Discount Rate

Once the future cash flow estimates are ready, you’ll need to discount them back to the present day using a discount rate. Applying the right discount rate determines the current worth of those future earnings.

For company valuation, the discount rate is usually the company's weighted average cost of capital (WACC). A firm’s WACC is like the average interest rate it has to pay to everyone who has invested in it (both lenders and shareholders), considering how much money each group has put in.

A higher discount rate lowers the present value of future cash flows, while a lower discount rate increases it. This can significantly influence whether an investment is considered viable.

3. Calculate the Present Value of Future Cash Flows & Terminal Value

The next step is to perform the calculations. Discount each year's forecasted cash flow to its current value using the chosen discount rate. The formula for discounting is: 

Where: 

• CF₁, CF₂, ... CFₙ represent the projected cash flows in each respective year
• r is the discount rate (e.g., the WACC)

In addition, a terminal value is often calculated to reflect the value of the company beyond the explicit forecast period.

The terminal value can be calculated in two ways:

• Perpetuity Growth Method (Gordon Growth Model):
  This method assumes that free cash flows will grow at a constant rate g indefinitely after the final forecast year. The formula is:
  
   
  
  Here, CFₙ₊₁ is the cash flow in the year following the last explicit forecast year, r is the discount rate, and g is the assumed long-term growth rate.
• Exit Multiple Method:
  This method assumes the company is sold at the end of the forecast period for a specific multiple (e.g., EV/EBITDA). The terminal value is then calculated as:
  
  
   

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4. Sum Present Values

Add together the present values of all future cash flows. This sum represents the total present value of the investment, or the DCF value. 

You can then compare the DCF value with the current market price or cost of the investment. If the DCF value is higher than the investment cost, the opportunity may offer positive returns hence worthwhile.
 

Discounted Cash Flow Analysis Example

A company is evaluating a new manufacturing facility project. The company's WACC is 8% and the initial investment required is $15 million. This project will last for six years with the following estimated cash flows:

If you use the DCF formula shared above and the 8% discounting rate, the discounted cash flows will look like this:

• Year 1: $2.5 million / (1 + 0.08)¹ = $2,500,000 / 1.08 = $2,314,815
• Year 2: $3.5 million / (1 + 0.08)² = $3,500,000 / 1.1664 = $3,000,686
• Year 3: $4.5 million / (1 + 0.08)³ = $4,500,000 / 1.2597 = $3,571,800
• Year 4: $5.5 million / (1 + 0.08)⁴ = $5,500,000 / 1.3605 = $4,042,632
• Year 5: $6.5 million / (1 + 0.08)⁵ = $6,500,000 / 1.4693 = $4,423,195
• Year 6: $7.5 million / (1 + 0.08)⁶ = $7,500,000 / 1.5869 = $4,726,196
• Then the total DCF = $2,314,815 + $3,000,686 + $3,571,800 + $4,042,632 + $4,423,195 + $4,726,196 = $22,079,324

From here we can get the Net Present Value (NPV) of the project by subtracting the initial investment from the DCF value. 

NPV = $22,079,324 - $15,000,000 = $7,079,324

With a positive NPV of approximately $7.08 million, this project can be worth making as it's expected to create more value for the company above the required 8% return rate.
 

Common DCF Interview Questions 

DCF-related questions are common in finance interviews, especially in investment banking and private equity. Here are some common DCF interview question and possible answers.

1. Walk me through a DCF

A DCF determines the value of a company by calculating the present value of its projected future cash flows.

To begin, the company’s financial projections are developed based on assumptions about revenue growth, expenses, and working capital. These projections are used to calculate the free cash flow for each year. Next, these cash flows are discounted to a present value using the discount rate, which is typically the Weighted Average Cost of Capital (WACC).

Then sum up the present value of the cash flows to estimate the company’s net present value. 

2. How do you calculate WACC?

The formula for calculating the Weighted Average Cost of Capital (WACC) is:

Each percentage represents the proportion of the company's capital structure made up by equity, debt, or preferred stock.

3. What would have more impact on a DCF valuation: A 1% change in discount rate or 10% change in revenue? 

The answer depends on the specific circumstances, but in most cases, a 10% change in revenue will have a greater impact. This is because revenue changes affect not only the current year's cash flow but also extend to future cash flows and the terminal value.

4. What are the pros and cons of a DCF valuation ?

Pros 

• Helps in valuing investments and making informed choices
• It’s flexible to adapt to various scenarios and assumptions 

Cons

• Relies on assumptions which can lead to missed opportunities or wrong investments if not solid
• Requires detailed financial knowledge and data
   

Key Takeaways  

A DCF analysis tries to determine what a company is worth today based on how much cash it's expected to generate in the future, taking into account the time value of money and the risk associated with those future cash flows.

The estimates for free cash flows and discount rate must be as solid as possible for the DCF value to be useful.

WACC takes into account the cost of equity (returns expected by shareholders) and the cost of debt ( interest rates on loans), weighted by their proportion in the company's capital structure.

👉 Want to master DCF analysis and other key valuation methods? Then check out this question set we've prepared for you in the Case Library!