What is Discounted Cash Flow Method?
The Discounted Cash Flow (DCF) is a valuation method that calculates an investment’s worth by forecasting its future cash inflows.
The essence of DCF analysis is to ascertain the present value of an investment, grounded on the anticipated future earnings it will produce.
This method is beneficial for those contemplating company acquisitions or securities purchases, providing them with a solid basis for their decisions.
Furthermore, DCF analysis can guide entrepreneurs and executives when they need to decide on capital allocation or operational spending.
Quick Takeaways
- The Discounted Cash Flow (DCF) approach is useful for evaluating an investment by discounting predicted future cash inflows to their present value.
- If the DCF exceeds the investment cost, it indicates potential profits.
- Often, the Weighted Average Cost of Capital (WACC) is used as the discount rate, reflecting expected shareholder returns.
- However, DCF’s reliability is compromised by the potential inaccuracy of future cash flow forecasts.
Discounted Cash Flow Formula
To use the Discounted Cash Flow analysis, here’s a simplified formula:
This is where:
- DCF is the total discounted cash flow
- t is when the cash flows are expected
- CFᵗ is the net cash flow during the period t
- r is the discounted rate
- N is the total number of periods
This formula calculates the present value of future cash flows, discounted back to the present using a discount rate r.
The sum of these discounted cash flows gives us the total discounted cash flow.
Better Understanding DCF
The goal of Discounted Cash Flow (DCF) analysis is to calculate the potential earnings an investor could gain from an investment, taking into account the time value of money.
The time value of money principle suggests that a dollar in hand today is more valuable than the same dollar received tomorrow, given its potential to earn returns if invested.
Therefore, DCF analysis is beneficial in scenarios where upfront payments are made with the expectation of higher returns in the future.
For instance, with an annual interest rate of 5%, a dollar in a savings account today will grow to $1.05 in a year. Conversely, if a dollar payment is postponed by a year, its current worth is 95 cents, as it loses the opportunity to earn interest in a savings account.
DCF analysis calculates the present value of anticipated future cash flows using a discount rate. This allows investors and acquirers to evaluate if the future earnings of an investment or project outweigh the initial investment or purchase value.
If the calculated DCF value is greater than the current acquisition cost, the business may be worth acquiring. However, if the calculated value is lower than the cost, the acquisition might not be a good opportunity, or it might require further research and analysis before making a decision.
To carry out a DCF analysis, an investor needs to predict future cash flows and the final value of the investment, machinery, or other assets.
The investor also needs to select a suitable discount rate for the DCF model, which will differ based on the specific project or investment. Factors like the risk profile of the company or investor and the state of the capital markets can influence the chosen discount rate.
If the investor is unable to predict future cash flows, or if the project is overly complicated, the DCF model may not be very useful, and other models should be considered.
There is also a similar but simpler method called Times Revenue Method. But the downside? It doesn’t take into account cash flow timings.
Feeling Overwhelmed?
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Example of DCF for Small Businesses
Let’s say you’re planning to sell your small business based in Texas. To determine a fair selling price, you decide to use the Discounted Cash Flow (DCF) method.
Your business’s Weighted Average Cost of Capital (WACC), which you’ll use as your discount rate, is 3%. Small businesses often have lower WACCs compared to larger corporations. Generally, this is because of the following reasons:
- Capital structure: Small businesses rely more on equity financing, which is typically cheaper than debt financing used by larger companies.
- Risk perception: Smaller businesses are often perceived as riskier, requiring lower rates of return to attract capital or secure loans.
- Cost of capital: Larger companies have higher administrative and operational costs than small businesses, increasing their overall cost of capital.
- Information asymmetry: Small businesses may face challenges in accessing capital due to limited information availability, leading to higher required rates of return.
You expect the business to generate cash flows for the next five years. You’ve estimated the following cash flows per year:
| Year | Cash Flow |
|---|---|
| 1 | $1,500,000 |
| 2 | $1,600,000 |
| 3 | $1,700,000 |
| 4 | $1,800,000 |
| 5 | $1,900,000 |
Using the Discounted Cash Flow formula, you calculate the discounted cash flows for the project as follows:
| Year | Cash Flow | Discounted Cash Flow (Rounded to the Nearest $) |
|---|---|---|
| 1 | $1,500,000 | $1,456,310 |
| 2 | $1,600,000 | $1,513,592 |
| 3 | $1,700,000 | $1,567,398 |
| 4 | $1,800,000 | $1,617,647 |
| 5 | $1,900,000 | $1,664,207 |
Adding up all of the discounted cash flows gives you a total of $7,819,156 or $7,800,000 if you’re not that into numbers. This is the estimated value of your business based on its future cash flows.
Therefore, you might consider setting the selling price around this value.
Pros and Cons of the Discounted Cash Flow Method
A bit simple, don’t you think? However, like any other method, the Discounted Cash Flow method has its own set of advantages and disadvantages.
Let’s hear them out.
Advantages of the DCF
Objective Valuation: The DCF method provides an objective measure of the value of a business based on its expected future cash flows that both the seller and buyer of the business have the potential to agree upon.
- Provides a clear, quantifiable basis for negotiation.
- Based on financial fundamentals, not market sentiment or speculation.
Incorporates Time Value of Money: The DCF method takes into account the time value of money, recognizing that a dollar today is worth more than a dollar in the future.
- Recognizes that money has a different value over time.
- Allows for a more accurate valuation of long-term investments.
Flexibility: The DCF method allows for the inclusion of different scenarios and assumptions about the future performance of the business.
- Can incorporate different scenarios and assumptions.
- Allows for the inclusion of unique business characteristics and growth potential.
Disadvantages of the DCF
Reliance on Assumptions: The DCF method relies heavily on assumptions about future cash flows and the discount rate.
- Small changes in assumptions can lead to significant changes in valuation.
- Risk of over- or under-valuation due to inaccurate assumptions.
Complexity: This method can be complex and difficult to understand for those without a financial background.
- Can be difficult to understand and apply correctly without a financial background.
- May require professional assistance, adding to the cost of the valuation.
Less Reliable for Small, Unstable Businesses: It may be less reliable when used to value small, unstable businesses with unpredictable cash flows.
- Less reliable for businesses with unpredictable cash flows.
- Less effective for businesses with a short operating history.
Final Thoughts
It’s now clear to us that the Discounted Cash Flow (DCF) is a powerful tool for evaluating the potential profitability of investments—whether they involve business acquisitions, securities purchases, or capital allocation.
It factors in the time value of money, allowing investors to evaluate whether the future earnings of an investment or project outweigh the initial investment or purchase value. However, it is also important to note that the DCF analysis is dependent on accurate forecasts of future cash flows, which can sometimes be challenging to predict.
And if you’re looking to sell your business that has a long-operating history in Texas, it’s crucial to understand the value of your business accurately.
This is where we, Tsetserra Growth Partners, can assist. The legacy of your business is what matters to us—and we don’t plan on leaving you for short-term agendas. We believe in your business’s future.
Our free Business Valuation tool can help you understand the worth of your business without the need to explore complex financial models. In just a few clicks, you’ll get your answer. Let’s get right on to it!
