In financial analysis, few tools are as revered—or misunderstood—as the Discounted Cash Flow (DCF) model. Often viewed as a crystal ball for determining a business’ intrinsic value, the DCF model provides a framework for evaluating the potential of future cash flows through the lens of today’s realities.
At its core, the DCF model revolves around a simple yet powerful concept: the time value of money (a dollar today is worth more than a dollar tomorrow). The model seeks to quantify this relationship, translating forecasts of future performance into present-day values.
So, what is the discounted cash flow model, how does it work, what is the formula, and when can it be used?
What Is The Discounted Cash Flow (DCF) Model?
The discounted cash flow (DCF) model is a financial valuation model that estimates a company’s intrinsic value (what the company is worth) based on its expected future cash flows. It operates on the fundamental principle that money today is worth more than the same amount in the future due to factors like inflation and opportunity cost.
Because of this, investors always compare a company’s estimated intrinsic value and its current market value to determine if an investment should be undertaken. Generally speaking:
- An investment should be considered if the company’s market value is lower than its estimated intrinsic value.
- If the company’s market value exceeds its estimated intrinsic value, investment should not be considered.
It’s worth noting that there isn’t one correct value for intrinsic value. Because the model requires personal assumptions about a company’s future, your estimate of intrinsic value will differ from your friend’s or an analyst’s.
How Does The Discounted Cash Flow (DCF) Model Work?
The discounted cash flow model calculates a company’s intrinsic value by forecasting its future free cash flows and discounting them back to today’s value using an appropriate discount rate.
Since the discount rate is the denominator of the DCF formula, the higher the discount rate, the lower the present value of a company’s future cash flows (lower present values = lower company valuations). Investors then compare this estimate of intrinsic value to the company’s current market value to decide if the company is worth investing in.
So why are future cash flows discounted? And what does discounting even mean?
The answer to the first question is…the time value of money.
Shareholders are paid from a company’s free cash flows. But future free cash flows aren’t worth the same in the present as in the future. This revolves around the principle that £1,000 today is worth more than £1,000 in five years – we can’t spend that future £1,000, we can’t invest it, and we have to account for inflation. So, we discount it using an appropriate interest rate to determine what it is worth to us now.
Therefore (answering the second question), discounting determines the present value of streams of future cash flows by accounting for the time between the date of valuation and the time of receipt. Discounting by an appropriate discount rate gives investors a better idea of what £1,000 of cash flow in five years is worth today.
For example, using a 5% discount rate, £1,000 in five years is equivalent to £784 today. At 10%, it would be worth £621.
That example also illustrates that the higher the discount rate, the lower the present value of future free cash flows.
What Assumptions Are Needed For A DCF Model?
Discounted cash flow models can get particularly complex, depending on how much control an investor wants over the intrinsic value outcome.
For a simple DCF, investors must make the following assumptions about the company being valued.
- Free Cash Flow Growth Rate – the expected free cash flow percentage growth the company will experience over the forecast period. This assumption can be influenced by analyst expectations, company expectations and an investor’s overall outlook.
- Discount Rate – the rate at which the future cash flows are discounted back to today’s value. This figure is usually the company’s weighted average cost of capital (WACC). WACC is a collective term that combines a company’s cost of debt (the interest rate on the company’s debts and other interest-bearing liabilities) and its cost of equity (the minimum required return shareholders expect for investing in the company).
- Terminal Value – reflects the total value of a company’s cash flows beyond the forecast period. There are two ways to calculate a company’s terminal value for the DCF model:
- Perpetual Growth Rate – an assumption of the rate at which the company will grow its cash flows indefinitely. This figure is usually the company’s country of origin’s average GDP growth rate.
- Exit Multiple – a figure by which the final year’s estimate of free cash flow is multiplied. The company’s average price-to-free cash flow multiple is often used.
- Margin of Safety – the difference between the company’s estimated intrinsic value and the investor’s buying price. A margin of safety protects the investor, to an extent, from forecasting errors. So, if an investor wants a 50% margin of safety, their buy price will be half of their estimate of intrinsic value.
Discounted Cash Flow Formula & Examples
In its simplest form, the discounted cash flow formula is as follows:
Where:
- CF1 = cash flow for year one
- CF2 = cash flow for year two
- r = the discount rate (the denominator is always raised to the power of the year of the cash flow).
- n = number of years
This formula is used when the investment’s future cash flows are known.
For example, let’s assume a company knows its future free cash flows, and they are as follows:
| Years | Future Cash Flows |
| Year 1 | £10,000 |
| Year 2 | £12,000 |
| Year 3 | £20,000 |
| Year 4 | £9,000 |
| Total | £51,000 |
Then, at a 10% discount rate, their present values would be:
| Years | Future Cash Flows | Discounted Cash Flows |
| Year 1 | £10,000 | £9,091 |
| Year 2 | £12,000 | £9,917 |
| Year 3 | £20,000 | £15,026 |
| Year 4 | £9,000 | £6,147 |
| Total | £51,000 | £40,182 |
If the company’s current market value is less than £40,182, investment should be considered.
A more advanced and probably more used version of the DCF formula is as follows:
Where:
- CF0 = the company’s current free cash flow figure
- g = free cash flow growth rate percentage (raised to the power of the cash flow)
- r = the discount rate (the denominator is always raised to the power of the year of the cash flow).
This formula is used when the investment’s future cash flows are unknown.
For example, if a company has a current free cash flow of £10,000 and an investor estimates the free cash flow growth rate to be 12% per year, its future free cash flows would be:
| Years | Future Cash Flows |
| Year 1 | £11,200 |
| Year 2 | £12,544 |
| Year 3 | £14,049 |
| Year 4 | £15,735 |
| Total | £53,528 |
At the same 10% discount rate, the present value of these cash flows would be:
| Years | Future Cash Flows | Discounted Cash Flows |
| Year 1 | £11,200 | £10,182 |
| Year 2 | £12,544 | £10,367 |
| Year 3 | £14,049 | £10,555 |
| Year 4 | £15,735 | £10,747 |
| Total | £53,528 | £41,852 |
Like the first example, investment should be considered if the company’s market value is less than £41,852.
When Can The Discounted Cash Flow (DCF) Model Be Used?
Since the discounted cash flow model is a long-term valuation model, using it for short-term investments is a pitfall.
Bearing this in mind, a DCF analysis can be used on any multi-year investment where streams of cash flow are known, such as bonds, or where the cash flows are to be forecasted, such as companies.
Summary
The discounted cash flow (DCF) model is a cornerstone of financial analysis and valuation and offers a structured way to determine a company’s intrinsic value. By breaking down the future into a series of cash flows and accounting for the time value of money, the model provides some clarity in an otherwise uncertain world.
While the model provides a systematic approach to estimating intrinsic value, its accuracy is highly dependent on the quality of input assumptions, such as future free cash flow growth and the discount rate.
As with all financial models, critical thinking and careful judgment are necessary to avoid possible pitfalls.
Share this post: