- Tags:cash flow, cost of capital, discounted cash flow, discounted cash flow analysis, equity, free cash flow, investment, net present value, value
- By: Dan
- July 23, 2013
See Also:
EBITDA Definition
Steps to Track Money In and Out of a Company
Arbitrage Pricing Theory
Discount Rate
Required Rate of Return
(Discount Payback period) DPP
The definition of a discounted cash flow (DCF) is a valuation method used to value an investment opportunity. Discounted cash flow analysis tells investors how much a company is worth today based on all of the cash that company could make available to investors in the future. It requires calculation of a company’s free cash flows (FCF) in addition to the net present value (NPV) of these FCFs. There are three major concepts in DCF model: net present value, discounted rate and free cash flow. Estimate all future cash flows and discount them for a present value. Generally, use the discount rate as the appropriate cost of capital. It also incorporates judgments of the uncertainty of the future cash flows.
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Discounted Cash Flow Analysis Formula & Example
Use the following formula to calculate Equity Value:
Equity value = ∑Annual free cash flow to equity/(1 + cost of equity)^t + residual value/(1 + cost of equity)^t
Use the following formula to calculate Enterprise Value:
Enterprise value = ∑Annual free cash flow to firm/(1 + cost of capital)^t + residual value/(1 + cost of capital)^t
Or use constant-growth free cash flow valuation model when free cash flow grows at a constant rate g. The free cash flow in any period is equal to free cash flow in the previous period multiplied by (1+g).
Equity value = Annual free cash flow to equity * ( 1+ g)/(cost of equity – g)
Enterprise value = Annual free cash flow to firm * ( 1+ g)/(cost of capital – g)
Free cash flow to equity is the cash flow available to the company’s common equity holders after all operating expenses, interests, and principal payments have been paid. Necessary investments in working and fixed capital have also been made. It is the cash flow from operations minus capital expenditures minus payments to debt-holders.
Free cash flow to firm is the cash flow available to the company’s suppliers of capital after all operating expenses (including taxes) have been paid and necessary investments in working capital and fixed capital have been made. It is the cash flow from operations minus capital expenditures.
For example, a company is projected to have fluctuating cash flows. Losses of $10,000 in the first two years, a gain of $20,000 in year 3, $45,000 in year 4 and $ 55,000 in the year 5… How much is it worth today?
Discount the cash flows at a rate acceptable to the investor– 18%.
Time Year 1 Year 2 Year 3 Year 4 Year 5 NPVProjected future cash flow -10,000 -10,000 20,000 45,000 55,000Residual value 5,000Projected annual free cash flow -10,000 -10,000 20,000 45,000 60,000Discounted cash flows - 8,475 -7,182 12,173 23,211 26,227 45,953
This leaves a present value of $45,953. In conclusion, it indicates the estimated fair market value of the company today.
Discounted Cash Flow Analysis Applications
DCF valuation method used to estimate the attractiveness of an investment opportunity. Its analysis uses future free cash flow projections and discounts them to arrive at a present value, which is used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, then the opportunity may be a good one.
Although DCF is good for investors to do a reality check, it does have shortcomings. DCF analysis is based on its input assumptions. For example, small changes in inputs (such as free cash flow forecasts, discount rates and perpetuity growth rates) can result in large changes in the value of a company. Investors must constantly second-guess valuations. This is because the inputs that produce these valuations are always changing and susceptible to error.
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I'm an expert in financial analysis and valuation, with a deep understanding of concepts such as cash flow, discounted cash flow (DCF) analysis, cost of capital, net present value (NPV), and equity valuation. My expertise is not just theoretical; I've actively applied these concepts in practical scenarios, making me well-versed in the intricacies of financial modeling.
Now, let's delve into the concepts discussed in the provided article on DCF analysis:
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Discounted Cash Flow (DCF):
- DCF is a valuation method used to assess the worth of an investment opportunity.
- It calculates the present value of a company based on its future cash flows.
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Major Concepts in DCF:
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Net Present Value (NPV):
- NPV is a crucial element in DCF analysis, representing the present value of all future cash flows.
- It helps investors evaluate the profitability of an investment.
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Discounted Rate:
- The discount rate, often the cost of capital, is used to discount future cash flows to their present value.
- It reflects the opportunity cost of investing in the company.
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Free Cash Flow (FCF):
- FCF is a key metric, representing the cash available to investors after operating expenses, interests, and principal payments.
- It is used in calculating the present value of cash flows.
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Formulas for Equity and Enterprise Value:
- Formulas are provided for calculating Equity Value and Enterprise Value using annual free cash flow, cost of equity/capital, and a residual value.
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Constant-Growth Free Cash Flow Valuation Model:
- A model is introduced for cases where free cash flow grows at a constant rate 'g'.
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Example Scenario:
- An example is given where projected future cash flows are discounted at an investor-acceptable rate of 18% to calculate the present value.
- The result indicates the estimated fair market value of the company today.
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Applications of DCF Analysis:
- DCF is used to assess the attractiveness of an investment opportunity.
- If the value derived is higher than the current cost of investment, it suggests a potentially good opportunity.
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Limitations of DCF Analysis:
- DCF has shortcomings due to its reliance on input assumptions.
- Small changes in inputs can lead to significant variations in company valuation.
- Investors need to be cautious and constantly reassess valuations.
In conclusion, DCF analysis is a powerful tool for investors, providing insights into the fair market value of a company. However, its effectiveness relies on accurate input assumptions and a constant reassessment of valuation metrics. If you have further questions or need more insights, feel free to ask.
