What Is Discounted Cash Flow (DCF)?

Discounted cash flow (DCF) is a 澳洲幸运5开奖号码历史查询:valuation method that estimates the value of an investment using its expected future 澳洲幸运5开奖号码历史查询:cash flows. Analysts use DCF to determine the 澳洲幸运5开奖号码历史查询:value of an investment today, based on projections of h𒁃ow much money that investment will generate in theღ future.

Discounted cash flow can help investors who are considering whether to acquire a company or buy securities. Discounted cash flow analysis can also assist business owners and managers in making capital budgeting or operating expenditures decisions.

How Does Discounted Cash Flow (DCF) Work?

Discounted cash flow analysis finds the 澳洲幸运5开奖号码历史查询:present value of expected future cash flows using a 澳洲幸运5开奖号码历史查询:discount rate. Investors can use the present value of money to determine whether the future cash flows of an investment or project are greater than the value of the init🐎ial investment. In other words, is the money this investment is likely to generate🙈 in the future higher than what will be invested right now?

If it is, the investment will be profitable and is worth considering. If it is not, the investment isn't a good idea.

Discounted cash flow analysis is used to estimate the money an investor might receive from an investment, adjusted for the 澳洲幸运5开奖号码历史查询:time value of money. The time value of money assumes that a dollar that you have today is worth more than a dollar that you receive tomorrow because it can be invested. As such, a DCF analysis can be useful in any situation where a person is paying money in the present with expectations of receiving more money in the future.

For example, assuming a 5% annual interest rate, $1 in a savings account will be worth $1.05 in a year. Similarly, if a $1 payment is delayed for a y🔯ear, its present value is 95 cents because you cannot transfer it to your savings account to earn interest.

To conduct a DCF analysis, an investor mಞust make esti🃏mates about future cash flows and the end value of the investment, equipment, or other assets.

The investor must also determine an appropriate discount rate for the DCF model, which will vary depending on the project or investment under consideration. Factors such as the company or investor's risk profile and the conditions of the capital markets can affect the discount rate chosen.

If the investor cannot estimate future cash flows or the project is very complex, DCF will no♈t have much value.

Discounted Cash Flow Formula

澳洲幸运5开奖号码历史查询: The formula for DCF is:

$\begin{aligned}&DCF = \frac{ CF_1 }{ ( 1 + r ) ^ 1 } + \frac{ CF_2 }{ ( 1 + r ) ^ 2 } + \frac{ CF_n }{ ( 1 + r ) ^ n } \\&\textbf{where:} \\&CF_1 = \text{The cash flow for year one} \\&CF_2 = \text{The cash flow for year two} \\&CF_n = \text{The cash flow for additional years} \\&r = \text{The discount rate} \\\end{aligned}$​DCF=(1+r)1CF1​​+(1+r)2CF2​​+(1+r)nCFn​​where:CF1​=The cash flow&nbs📖p;for&🎉nbsp;year oneCF2​=The cash flow for ye🔴ar twoCFn​=The cash flo🐼w for additional yeaꦗrsr=The discount rate​

Example of DCF

When a company analyzes whether it should invest in a certain project or purchase new equipment, it usually uses its weighted average cost of capital (WACC) a🐓s the discount rate to evaluate the DCF. The WACC incorporates the average rate of return tha♛t shareholders in the firm are expecting for the given year.

For example, say that your company wants to launch a project. The company's WACC is 5%. That means that you will use 5% as your discount rate.

The initial investment is $11 million, and ✤the project will last for five years, with the following estimated cash flows🅷 per year.

Us🌊ing t🌊he DCF formula, the calculated discounted cash flows for the project are as follows.

Adding up all of the discounted cash flows results in a value of $13,306,727. By subtracting the initial investment of $11 million from that value, we get a 澳洲幸运5开奖号码历史查询:net present value (NPV) of $2,306,727.

The positive number of $2,306,727 indicates that the project could generate a return higher than the initial cost—a positive return on the investment. Therꦕefore, the pꦅroject may be worth making.

If the project had cost $14 million, the NPV would have been -$693,272. That would indicate that the project cost꧙ would be more than the projected return. Thus, it might not be worth making.

෴ Advantages and Disadvantages of Discounted Cash Flow Analysis

Like an🦩y other form of financial analysis, there are advantages and disadvantages to using discounted cash flow analysis.

Advantages

Discounted cash flow analysis can provide investo🐓rs and companies with a reasonable projection of whether a proposed investment is worthwhile.

It is an analysis that can be applied to a variety of investments and capital projects where future cash flows can𝓀 be reasonably estimated.

Its projections can be tweaked to provide different results for various what-if scenarios. This can help users account for different projections that might be possible.

Disadvantages

The major limitation of discounted cash flow analysis is that it involves estimates, not actual figures. So the rꦜesult of DCF is also an estimate. That means that for DCF to be useful, individual investors and companies must estimate a discount rate and cash flows correctly.

Furthermore, future cash flows rely on a variety of factors, such as market demand, the status of the economy, technology, competition, and unforeseen threats or opportunities. These can't be quantified reliably. Inves🧸tors must understand this inherent drawback for their decision-making.

DCF shouldn't necessarily be relied on exclusively even if solid estimates can be made. Companies and investors should consider other, known factors as well when sizing up an investment opportunity. In addition, comparable company analysis and precedent transactions are two other, common valuation methods that might be used.

The Bottom Line

Discounted cash flow is a valuation method that estimates the value of an investment based on its expected future cash flows. By u𝐆sing a DFC calculation, inv💎estors can estimate the profit they could make with an investment (adjusted for the time value of money). The value of expected future cash flows is first calculated by using a projected discount rate.

If the disco🐼unted cash flow is higher than the current cost of🎐 the investment, the investment opportunity could be worthwhile.