Discounted cash flow – Concept and computation

If you have ₹ 1,00,000 today, will you lock it safely in your drawer or invest it elsewhere to make more money?

If the latter is your choice, you already have an idea about the time value of money.

According to the time value of money, the value of ₹ 1 today is more than the value of ₹ 1 on a later date. People who wish to use the money in hand today to increase its value, choose to invest.

The primary factors driving investment decisions are the time value of money and return on investments.

Both of these components are factored in, for valuing investments under the discounted cash flow technique.

What is DCF?

The full form of DCF is Discounted Cash Flow.

As the name suggests, this method uses future cash flows to ascertain the valuation or worth of investments.

The DCF is a valuation tool that aids in ascertaining the value of companies, assets, shares, bonds, etc.

If you want to earn ₹ 5,00,000 after five years, how much money should you invest today? The discounted cash flow method answers this for you. 

You may also like: What is return on sales and why is it important?

Understanding the discounted cash flow method

Under the discounted cash flow method, the amount of money required for making an investment today is compared to the return it is expected to yield in the future.

A good investment opportunity is where the returns are higher than the investment amount. Where the return is lower than the initial investment, the option is risky and prone to losses.

It is essential to keep in mind that the cash flows under DCF are on the basis of estimations. Hence, it is necessary to ensure the estimations are as accurate as possible.

DCF Formula

The two prime components to calculate discounted cash flow are – cash flows for future years and discount rates.

DCF = CF1 (1+r)1 + CF2 (1+r)2 + CFn (1+r)n

CF1 and CF2 represent cash flows for years 1 and 2.

r - represents the discount rate to derive the present value of investments.
n - represents the number of years.

The discount rate calculation under the discounted cash flow method varies from one investment to another.

If the investment is for a business or its assets, the Weighted Average Cost of Capital (WACC) is used. If the investment is in bonds, the rate of interest or yield is the discount rate.

Other ways to determine the discount rate are the sensitivity analysis, the hurdle rate method, etc. Investors can also determine discount rates using qualitative methods like the judgement and intuition approach.

Also Read: Enterprise value: What does it tell you about a company’s worth?

Discounted cash flow example

• Using the discounted cash flow method for investing in a business:

Mr. A wants to invest ₹ 3,00,000 in ABC Ltd for a period of 6 years. The WACC of the business is 4%. Use DCF to calculate the current value of future cash flows. 

Estimated cash flows:

DCF = 40,000 / (1+0.04)1 + 33,000 / (1+0.04)2 + 50,000 / (1 + 0.04)3 + 65,000 / (1 + 0.04)4 + 54,000 / (1+0.04)5 + 70,000 / (1+0.04)6

The sum of discounted cash flow for six years is ₹ 2,68,690. This is lower than the earlier investment of ₹ 3,00,000.

This suggests that the current value of future cash flows is less than the first investment by ₹ 31,310. So Mr A will incur a loss of ₹ 31,310 if he invests in ABC Ltd.

• Using the discounted cash flow method for investing in a debt fund

Mr. A wants to invest in a bond with the below details:
Face value: ₹ 1,500
Interest rate: 8 % p.a, payable annually
Yield to maturity: 5 %
Duration: 6 years
The interest amount on the bond is constant every year.
Interest = 1,500 * 8% = ₹ 120
DCF on interest payments: 120 / (1+0.05)1 + 120 / (1+0.05)2 + 120 / (1 + 0.05)3 + 120 / (1 + 0.05)4 + 120 / (1+0.05)5 + 120 / (1+0.05)6

Total discounted cash flow on interest payments = ₹ 610

Discounted cash flow on face value = 1500 / (1 + 0.05)6 = ₹ 1,119

So, the total present value of future cash flows on the bond is ₹ 1,729.

Since the present value of future cash flows is more than the initial investment of ₹ 1,500, this is a profitable investment for Mr A.

Pros and cons of DCF

Advantages of DCF:

• Discounted cash flow involves simple calculations that help investors make the right decisions. Since investors can calculate the returns beforehand, it acts as a warning for investors to stay away from loss-making investments.
• This method can be applied to various investments like businesses, shares, bonds, etc.
• The DCF valuation method is flexible. Investors can alter the numbers based on changing scenarios.

Limitations of DCF:

• The first and foremost disadvantage of using this method is the estimation. The discounted cash flow technique is built on estimated future cash flows. These can be inaccurate, leading to wrong investment suggestions.
• Even in cases where estimates for the future are accurate, the cash flows are prone to changes due to external factors in the market.

Bottomline

The DCF analysis is a popular way of measuring return on investments. The Net Present Value (NPV) which is the delta between the initial investment and discounted cash flows, is the key to making investment decisions under this method.

However, the DCF method is not a foolproof method for the valuation of assets. Hence, it is always suggested that the investors use other valuation techniques like ratios in parallel.