DCF valuation, short for Discounted Cash Flow valuation, is a financial model for determining whether an investment opportunity will be worthwhile. By projecting future cash flows and discounting them back to the net present value, investors can make smart choices about what investments are worth their resources- all based on solid financial data that has been used successfully in various fields of finance! Instead of leaving it up to guesswork or intuition, this reliable technique helps you determine if your potential investment is profitable.
What Is DCF Used For?
DCF valuations are widely used in the financial world, from corporate finance, mergers, and acquisitions to real estate investments and private equity. Beyond that, they can be useful for business owners who want to make sound budget decisions or calculate their own projected value. Essentially, these valuations assess whether or not an investment is worth it in the long run.
How Does Discounted Cash Flow (DCF) Valuation Work?
Money isn’t created equal; its value changes over time. That’s where the concept of ‘time value of money’ comes in. It states that $10 today is worth more than $10 a year from now. So, when we’re crunching numbers and analyzing cash flows for, say, DCF valuation– future projected amounts need to be discounted back to present values so they can be accurately assessed.
For instance, with an annual interest rate of 5%, $1 in a savings account will be worth $1.05 in one year. On the other hand, if you delay a payment of $1 for one year, its present value is 95 cents since you don’t get to take advantage of adding it to your savings account and earning interest.
Conducting a DCF analysis requires an investor to make educated guesses about future cash flows and the final value of their investment, equipment, or other assets. The discount rate chosen for the DCF model may vary depending on the project or investment being examined and is determined by factors such as the risk profile of the company or investor and current capital market conditions.
If the investor cannot accurately forecast future cash flows or the project is too complex, then DCF won’t be of much use, and other models should be used instead.
What Is the DCF Valuation Formula?
When it comes to performing a Discounted Cash Flow (DCF) valuation, there are three key components to consider: the discount rate, cash flows, and the number of periods. The formula for DCF is:
Cash Flow (CF): It’s any type of income that is earned or received. It can come from the sale of products or services and assets, as well as from investments such as bonds. Cash flows include both inflows and outflows- this includes things like revenue, dividends, principal payments, etc. In a DCF formula, cash flow is often referred to as CF1 (cash flow for the first year), CF2 (cash flow for the second year), and so on.
Number of Periods (n): The number of periods used in a Discounted Cash Flow (DCF) valuation can vary depending on the time over which cash flows are estimated. Generally, this period is 10 years as it’s the average lifespan of most businesses. However, depending on the specific company, it could be shorter or longer.
Discount Rate (r): The discount rate is used to bring future costs into current value. Generally, it reflects the company’s cost of capital- that is, how much money must be made to justify its operating expenses. This is often calculated using the weighted average cost of capital (WACC), which considers both loan and dividend payments given to shareholders.
Example Of DCF Valuation
Imagine that you own a company and have decided to undertake a major project. The weighted average cost of capital for your business is estimated to be around 8%. Hence, you should use this rate as your discount rate for the project. Plus, the venture is expected to span over five years and demands a whopping $15 million investment from your company’s end.
Cash flows for the project are:
- 1st year: $1 million
- 2nd year: $2 million
- 3rd year: $5 million
- 4th year: $5 million
- 5th year: $7 million
By factoring in the projected cash flows with your 8% rate of discount, you can calculate yearly discounted cash flows as follows:
|Projected Cash Flow
|Discounted Cash Flow*
After assessing the initial investment of $15,000,000 and evaluating the discounted cash flows that are expected to be generated by the project, it has been determined that this investment holds potential for profitability.
The total sum of discounted cash flows that are expected to be generated throughout the project lifetime comes to $15,048,996, which is greater than the initial investment cost. By calculating the net present value (NPV) of this project, which is determined by subtracting the initial investment cost from the sum of the discounted cash flows, we are left with a positive figure of $48,996. This indicates that the generated returns from the project will exceed the initial investment cost, making it an investment worth considering.
How Can You Include DCF Skills on Your Resume?
Finance professionals frequently use DCF valuation as a means of financial modeling. An individual can include DCF skills on a resume in two ways.
They can list “financial modeling” in their skills section, along with DCF and any other relevant modeling skills. Alternatively, previous work or internship experience can be highlighted where a DCF model was created.
Discounted Cash Flow (DCF) is a useful tool for businesses seeking to examine potential investments. It provides a way for business owners to calculate the net present value of an investment, allowing them to determine whether a venture is worth pursuing. The main advantage of DCF is its versatility, as it can be applied to a wide range of firms, projects, and other investments as long as future cash flows can be estimated accurately.
With practice, anyone can become proficient in this financial model. After all, demonstrating proficiency in DCF on a resume can benefit finance professionals when looking for work or internships.
How Do You Calculate DCF?
There are three main steps for calculating DCF:
- You must project the cash flows that will be generated from the investment.
- Select a suitable discount rate based on either the cost of financing the investment or better alternatives.
- Use either a financial calculator or spreadsheet to discount the projected cash flows back to present-day value.
How is a stock valued using DCF?
To value stock with DCF, calculate the average free cash flow (FCF) for the past 3 years. Then, estimate future FCF by multiplying this average with a predicted growth rate. Finally, divide estimated future cash flows by a discount factor to calculate the net present value.