Definition:

Discounted cash flow (DCF) analysis is a method of valuing an asset using the time value of money to determine expected cash flows in the future. Based on these expected future cash flows, given in their present value, one is able to determine the value of the asset in question. DCF Analysis is widely used in finance to value companies, real estate development, and internal corporate projects. In DCF analysis, the present value of a company is the summation of the present value of all future cash flows plus the value of current assets.


DCF History:

DCF calculations have been used in financial calculations as far back as ancient times. As a method of asset valuation it has often been opposed to accounting book value, which is based on the amount paid for the asset. After the stock market crash of 1929, DCF analysis gained popularity for stock valuation. In its current economic form, Irving Fisher’s 1930 text “The Theory of Interest” first discussed DCF as a viable method of valuation.


Mathematics:

DCF

Where:
• DCF = Net Present Value (NPV) of all future cash flows
• FCFY = Future cash flows in year Y
• R = the current discount rate (often based on WACC) which reflects the cost of tying up capital and may also allow for the risk or the payment not being received in full
• N = number of years the cash flow is expected to exist


Example:

Assume you have a choice of receiving $1000 today, or a year from now. You would probably elect to take the $1000 today because you could invest it, and have more than that amount in a year. The present value of the $1000 in a year is simply the initial $1000 plus the amount you could expect to make over the year. Inversely, the discounted value is today’s value of a $1000 in a year.


Advantages:

• DCF analysis is often the soundest method of valuation since it uses a number of intrinsic and external factors to determine the value of an asset.
• Because DCF analysis is forward-looking. it depends more on future cash flow expectations than historical financial results.
• It is focused on cash flow generation and is less affected by accounting practices and assumptions.
• It allows for greater flexibility - DCF analysis allows different components of a business to be valued separately, therefore factors impacting isolated parts of a business can be assessed independently.


Disadvantages:

• DCF analysis can vary greatly with the accuracy of its assumptions. Cash flow forecasts, discount rates, and growth rates are all debatable factors to consider.
• Cash flow forecasts, choice of discount rates, growth rates – the accuracy of these estimates will all have significant influence on how accurate a DCF is.
• Since markets are constantly changing, so too are assumptions in the model. Therefore, the Net Present Value of future cash flows often fluctuates with changing assumptions.


References:

• Fisher, Irving: “The Theory of Interest: As Determined by Impatience to Spend Income and Opportunity to Invest It”, The Macmillan Company, 1930