Discounted cash flow is a method of analyzing a company by forecasting its cash flows and discounting the cash flows to arrive at a present value.
It estimates the company’s intrinsic value based on future cash flow. The idea behind the DCF model is that the value of the company is not a function of demand and supply of the stock. Instead, the value of the company is a function of the ability to generate future cash flow for its shareholders
BASICS OF DISCOUNTED CASH FLOW MODEL:
The discounted cash flow method is based on the concept of the time value of money which means, the present value of money is worth more than the same amount in the future.
For example, if you have ten lakhs as a cash balance in your hand that will be worth more than one year later due to interest accrual and inflation.
If an investor is ready to invest one lakh now, he wants to know the return on investment and what its future valuation will be, which can be calculated through the DCF model.
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The DCF formula is as follows
DCF = CF1/ (1+R) ^ 2 + CF2 / (1+R) ^2 +… + CFn / (1+R) ^ n
CF = Cash Flow for the upcoming years
R = It denotes the discount rate. (It’s the rate which investors expect to receive on average from a company for financing its assets). In business, it’s Weighted Average Cost of Capital (WACC)
N = denotes the final year
For example, Mr. Bhavesh plans to make an investment of ten lakhs in business for a tenure of five years. The WACC of the business is 7%
The estimated cash flow of the business are mentioned below
Based on the formula
DCF = [200000/(1+0.07)^1 ] + [250000/(1+0.07)^2] + [175000/(1+0.07)^3] + [325000/(1+0.07)^4 ] + [400000/(1+0.07)^5]
The total discounted cash flow valuation will be 10, 81294. When deducting from the initial investment of ten lakhs, the Net Present Value will be 81,294. As the NPV is a positive number, Mr. Bhavesh’s investment in the business is attractive.
In case, if he had invested eleven lakh, he would have incurred a loss of 18706 as the NPV would have been negative.
Let us simplify the discounted cash flow techniques, here we will discuss, how to calculate the future value of your investment and present value of that investment.
Assume an individual invests a business for Rs. 15000 in a three year time period at the rate of return will be 8% per annum. Calculate the future value of our investment
FV = PV* (1+R) ^n
FV => Future Value
PV => Present Value
R = > Rate of Return
N => Number of years
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So what’s our future value of the investment?
That will be 18895 in three years. Come to the next scenario company offered you Rs. 15000 in a three years period and they asked how much you are willing to pay for the offer.
To answer this question, we must understand the discounted cash flow model. For a single transaction, we can calculate from the future value formula
PV = FV/ (1+R) ^n
*here R is the discounted rate or expected rate of return
For the above example we take, two different investors expected return
|FUTURE VALUE||EXPECTED RETURN||PRESENT VALUE|
It’s not a big deal to reach 15000 in three years but how much return investors are expecting.
If investors looking for high returns (16%) and they believe that the asset has the ability to generate this type of return. They should only offer Rs. 9610 to the business.
- If anyone wants to buy a stock or buying a business for that you need to project the expected future cash flows.
- If our investment is priced below the sum of discounted cash flows, it depicts the undervalue of the stock, and therefore, it’s an attractive investment for the investors.
- On the other hand, some of the discounted cash flow is high, the assets may be overvalued or our assumption may be wrong.
- This model is suitable for companies that are larger with relatively steady growth.
- DCF analysis is useful for mergers and acquisitions.