Discounted Cash Flow (DCF)

Discounted Cash Flow (DCF) is a financial valuation method that assesses the value of an investment based on its expected future cash flows, which are adjusted to reflect their present value. This analysis is grounded in the principle of the time value of money, which posits that a dollar today is worth more than a dollar in the future due to its potential earning capacity. The DCF model incorporates three key elements: the time period under consideration, the forecasted future cash flows, and the discount rate applied to these cash flows.

Typically, the discount rate reflects the risk associated with the investment, often determined through the weighted average cost of capital (WACC), which considers the mix of a company’s debt and equity financing. DCF can be applied to various contexts, including evaluating new business ventures and real estate investments, providing a framework for determining potential profitability compared to safer investment alternatives. However, while DCF is a widely used tool, it is not without limitations; the accuracy of its results heavily depends on the reliability of the input assumptions and can be affected by unforeseen market changes. Additionally, it primarily focuses on financial returns and may overlook broader environmental, social, and cultural impacts.

Published in: 2021

By: Kte’pi, Bill, MA

Subject Terms

Discounted Cash Flow (DCF)

Abstract

Discounted cash flow (DCF) is a valuation method used in the finance industry, in which the future cash flows of an investment are discounted according to various methods in order to determine the value of that investment. When used to evaluate the feasibility of a new business venture, it typically discounts future cash flows according to the weighted average cost of capital to determine if the venture’s profits will outweigh its costs within a certain period of time. As with all forecasting methods, DCF is not perfect, especially if the input data is unreliable.

Overview

Discounted cash flow (DCF), also called the discounted cash flow model, is a method of analysis used in the finance industry to determine the value of an asset (typically an investment, such as a business or a project) based on its future cash flows. It is closely related to, and sometimes confused with, the concept of net present value, which is determined using DCF. There are three basic elements of DCF: the period of time being considered, the future cash flows during that period of time, and the discount rate applied to those cash flows.

Savings accounts have long been used as an example of why money now is worth more than money later. If you receive $10 now instead of four years from now, you can put it in a savings account and earn interest on it over four years. While this example dates from a time when consumer savings accounts drew higher rates of interest than are common now, the basic principle is easy to understand: money now is more valuable than the same amount of money later because of the value-generating purposes to which that money can be put in the intervening time.

Discounted cash flow is one of several valuation models used in finance. Most valuation models are either option pricing models, used for certain kinds of investments, or models determining the relative or absolute value of an asset. Relative value models determine the value of the asset through comparisons to the market prices of similar assets, examining those assets’ sales, earnings, or other variables in order to extrapolate a predicted value for the analyzed asset. DCF is an absolute value model, also known as fundamental value or intrinsic value. It relies on mathematics rather than observation.

The DCF model is grounded in the idea of the time value of money. In economics, time preference is a concept used to express the degree to which someone would prefer to receive a good at an earlier date rather than at a later date. A loan is essentially grounded in this idea: receiving a certain amount of money now (via loan) instead of later (via savings or other low-risk investment) is worth at least as much to the borrower as the amount of interest charged by the lender. In some cases, this preference is reflected reasonably; barring aberrations in the housing market, most mortgages are offered at interest rates that are not outsized relative to the resale value of the home. In other cases, time preference is exploited to a degree that has been outlawed in some states, such as so-called payday loan services that offer short-term loans at extremely high interest rates to borrowers who have income but may be facing eviction or utility shut-off between paychecks.

Behavioral economists and psychologists have made many studies of the underlying reasons usurious lenders are able to operate. While some of it is because of economic conditions that leave the borrower with few other choices, people are also easier to exploit because of the way most perceive the time value of money: something to be received in the near future is assigned a greater value than something to be received in a more distant future, a phenomenon sometimes called temporal discounting. It is easy for people to talk themselves into making decisions that benefit them economically now at the expense of their “future selves.” This is true even when the expense clearly outweighs the economic benefit—for example, spending money from long-term savings to pay for a vacation—as long as that future is sufficiently distant.

Traditionally, economists have assumed that the discounting people assign as a result of time preference is exponential; studies in neurology have suggested it is actually hyperbolic, though this has not yet appreciably impacted standard practices. In hyperbolic discounting, perceived value falls off quickly in the short term, but decline slows considerably thereafter. For instance, a doughnut after lunch may feel much more valuable than a doughnut promised for tomorrow; but there is very little difference in value to be assigned to the promise of a doughnut three years from now and a doughnut four years from now.

Time preference is a psychological phenomenon, but with respect to investments, the time value of money is treated differently. The premise is the same: that it is better to have money now than later, that there is added value to money held in the present. By extension, for an investment to be worthwhile, there must be some return in the future that offsets the time value. Time preference explains why a borrower will take out a loan even on poor terms; this need for return on the investment addresses why the lender will extend the loan in the first place.

The time value of money is a concept underlying many phenomena and principles in economics and finance. Rational agents only part with their money if they can expect to profit sufficiently enough to make the wait to regain it worthwhile.

Determining the value of a company through DCF entails various methods according to the capital structure of the company—the combination of equity, debt, and hybrid securities through which the company finances its assets. The weighted average cost of capital approach is one such approach, but others include an adjusted present value (APV) analysis, which is well-suited to projects financed without significant amounts of debt capital; and a flows to equity analysis, which makes debt capital explicit.

Performing a DCF analysis requires determining the venture’s forecasted cash flows during the specified period of time. Many operational cash flows can be estimated fairly accurately. The cost of a business’s physical location can be expected to be fairly predictable, for instance—the mortgage, rent, or lease on its buildings or offices, the maintenance and utility costs thereof, the need for periodic repairs, all adjusted by reasonable growth rates to account for inflation and other factors. The same is true for many equipment and raw material costs, though many commodities like fuel and agricultural goods (“soft” commodities) experience frequent price volatility. Predicting inflows requires forecasting the business’s performance over time—that is, its expected growth in sales, as well as other sources of income.

Absolute value models can be either multi-period or single-period models. DCF is a multi-period model. A single-period model that is otherwise similar is the Gordon growth model, developed by Myron Gordon in 1956 for the valuation of a company’s stock price. The stock is valued by summing the future dividend payments paid to shareholders, discounted to present value.

Applications

DCF is calculated according to the following formula:

where CF represents each cash flow and r is the discount rate. (These abbreviations are not standardized, and different texts and manuals may use other terms.)

There are various methods of determining the discount rate. If the project being analyzed is a standard investment with a predetermined rate of return, like a savings account, bond, or a loan, the risk-free rate of return is used. This is a theoretical rate of return (the net gain over a period of time, as a percentage of the cost) that assumes zero risk; the odds of a bank closing and not honoring the interest on a savings account or a government not honoring a bond are close to negligible. Generally, the rate of return on a three-month U.S. Treasury bill is used as a proxy for the risk-free rate of return, because of the incredibly low odds of the American government defaulting on a short-term financial obligation. Foreign investors, however, are subject to currency risks as foreign currency exchange rates fluctuate.

DCF is frequently used to assess the potential of a new investment, such as a new business or a new project being considered by that business. In these cases, the risk-free rate of return is inappropriate for the discount rate, and the most common choice is the weighted average cost of capital (WACC), sometimes referred to simply as cost of capital. WACC examines the capital structure of a company, meaning the sources from which they raise money, including securities like stock and bonds, pension liabilities, or government subsidies. Because each security generates different returns, these different rates are calculated in proportion to their makeup of the company’s capital structure. The larger the company, the more complex its capital structure is, which is even more true in the twenty-first century because of changes in the finance sector and the handling and packaging of securities. Calculating WACC is a time-consuming and difficult endeavor, with the opportunity for errors increasing with the complexity.

Typically, after DCF for a proposed action (e.g., business venture, investment) is determined, the result is compared to the DCF for the same amount of initial capital at the risk-free rate. This is a vital step in the process. It is one thing to show that a proposed business venture will be profitable assuming that everything goes according to plan; it is more meaningful to show that the venture is not merely profitable but more profitable than doing nothing. In other words, such a venture returns more money to its investors than they would have made by simply investing in low-risk securities like Treasury bonds.

DCF can be used to determine the net present value of the venture as well, by first calculating the future value:

where DPV is the discounted present value and FV is the future value. The net present value is the sum of the DPV of all cash flows. Other formulas are used for special circumstances, like continuous cash flows.

Issues

Discounted cash flow analyses have been used to evaluate business ventures since the eighteenth century. In the twenty-first century it has become a standard tool in finance, banking, urban planning and related endeavors (e.g., government agencies use it to determine the economic impacts of planned developments or infrastructure), and intellectual property valuation. It also comes up in legal disputes, for instance, as a means of determining the value of a plaintiff’s asset or venture that has been damaged or otherwise impacted by the defendant.

DCF is a useful method of analysis, but like other analyses, it is vulnerable to “garbage in, garbage out” problems. If there are problems or inaccuracies in the values used in the formula, they will be carried over into—or amplified by—the analysis. As with any method of determining future value, it cannot account for unforeseen changes. In the case of valuing a company’s future cash flows, for instance, there could be changes to the cost of raw materials or other expenses, or changes to the competitive landscape of the industry that reduce the company’s profits or market share. Even changes to the tax structure can have significant impact on the accuracy of a DCF, and can be difficult to predict. The heavy use of DCF in the funding of commercial real estate ventures has been criticized precisely because of the methodology’s blind spots: Many real estate markets are cyclical, while the analysis assumes a linear increase to leasing incomes; and calculating the discount rate uses information from the present, which is likely to change on a sufficiently long timeline, because of the fluctuating conditions in which real estate investments are made.

Further, DCF focuses on only one metric of a venture’s advantages—the increase in cash value of the initial investment. This ignores environmental, social, and cultural impacts, and other “big picture” concerns, and does not distinguish between short-term and long-term value. Consider the case of comparing the DCF of a proposed business venture to the DCF of a low-risk investment. The difference may be small, or the business venture may even promise a lower rate of return than the investment. But the overall health of the economy—and of society—requires that capital be directed toward business ventures and other economic activities. The interest rates of low-risk investments are possible only because other monies are being circulated. Thus, the value created by a business venture is more significant than its rate of return or DCF. Some analysts focus instead on integrated future value, which considers DCF along with performance in the areas of environmental, social, and governance.

Terms & Concepts

Cash Flow: A measure of the cash going to and from a business; a positive cash flow means more cash is coming into the business (inflows) than is being paid out (outflows). In particular, analysts pay attention to a business’s free cash flow—the inflows minus the outflows necessary for operations and maintenance of capital assets. This is a more meaningful measure of a business’s performance than its net income. A business may generate extraordinary amounts of income, but if its expenses are just as extraordinary, its free cash flow may be proportionally small or even negative.

Discount Rate: With respect to discounted cash flow, the rate used in calculating the present value of future cash flows.

Net Present Value: The present value of cash inflows minus the present value of cash outflows, considered over a period of time.

Present Value: The value of an asset or business at the current time, rather than at a future point. It often represents the initial cost of an investment.

Valuation: The process of determining the monetary worth of something. In economics and finance, various methods of valuation are used for different purposes, such as finding the value of an investment or business. In finance, there are a number of valuation models used for different circumstances, including absolute or relative value models, and option pricing models.

Weighted Average Cost of Capital (WACC): Determines a business’s cost of capital while weighting each capital component—that is, adjusting them to reflect their proportional share of the total.

Bibliography

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Discounted Cash Flow (DCF)

On this Page

Subject Terms

Discounted Cash Flow (DCF)

Abstract

Overview

Applications

Issues

Terms & Concepts

Bibliography

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