Discounted Cash Flow (DCF) is a valuation method or fundamental analysis equation used to calculate the future cash flows of investments to derive their present value. Investors often use DCF to calculate the time value of money and the returns they will earn from an investment. Here, future cash flows are first calculated by estimate and then discounted to give present values. This discount rate represents the cost of capital and also the risk involved in future cash flows. DCF is a necessary calculation in investment financing, real estate development, and corporate financial management.
DCF can be calculated using the following formula:
DPV = VF/(1+i)n = VF(1-d)n
Here, DPV is the discounted present value for the future cash flow, FV represents the future value of the cash flow, is the interest rate of the cash used for the investment, n represents the number of years until the new cash flow enter the scene , and d is the discount rate assumed at the beginning of the year.
DCF does not depend on the amount of investment made, but on what the returns on that investment are. For example, even a smaller investment in real estate can generate a higher return than a much larger investment. Therefore, DCF is a very critical analysis when a company is evaluating different investment projects and has to prioritize the most profitable one.
History suggests that DCF arose when money was slow in ancient times. DCF is quite different from book value in that it is not based on the amount paid for the asset. From the stock Exchange 1929 accident, DCF became popular as an evaluation method.
There are several different DCF methods that can be used for valuation based on a company’s capital structure. They are also known as discounted future economic income methods.
1. Flows to capital (FTE)
Here, the cash flows to the equity holder are discounted after subtracting the debt principal. Although it is advantageous in certain cases, it still requires good judgment about the discount rate.
2. Set Present Value (APV)
Here the cash flows are discounted without subtracting the debtor capital, but rather the tax relief on the debtor capital. It requires a simple calculation on FTE.
3. Weighted Average Cost of Capital (WACC)
Here, a weighted cost of capital is obtained from different sources and used to discount cash flows.
Therefore, DCF can be used to determine the value of various business properties, such as shareholders or debt holders.
Furthermore, this can be used to value the company.
However, DCF is not without its critics. It is believed to be a mechanical valuation tool, as even minute changes in values can make a big difference in a company’s valuation, which can sometimes make a big difference. Terminal value techniques are sometimes used, as it becomes difficult to have realistic estimates of the cash flows for DCF as time passes.