Discounted Cash Flow Formula: What It Is And How To Use It

Discounted cash flow formula is one of the most reliable methods for company valuation. Learn the basics of discounted cash flow method, how it can be applied to all businesses and how to use it as a tool for measuring asset value.

As we have already discussed various methods for company valuation, Discounted cash flow formula or DCF formula is one of them.

The formula is a forecast of free cash flow in a company or more specifically “FCF” in short. The cash flow formula can be applied to all businesses. Companies can use discounted cash flow techniques as a tool for measuring their asset value.

The word discounted cash flow meaning, a method, usually investors or valuation experts use to find out the value of the business by assuming future cash flows value of a business.

The formula projects the business strength of how a business will perform in the future, then based on that ratio it’ll show you the value of how much money it will generate in future.

The DCF Formula is a time-tested way of finding out how much your business, technology startup is worth. Even if you are going to invest in a stock, this is the method you will use. It’s an equation, and it’ll take you about 10 minutes to learn and understand.

Discounted Cash Flow Formula (DCF) Guide

 

discounted cash flow formula guide
image: DCF Formula Guide

Discounted cash flow is an investment valuation technique based on estimating the value of an investment in today’s dollars. The DCF Formula is a popular way to find out the value of an investment or a business.

For growth and for future business opportunities, valuing your business is a smart decision. When you evaluate your business, you know what your business potential is and where you are.

If you are someone going to invest in a business, you’d be pleased to make a better decision. Isn’t that great?! When you know how your investment will serve you as per the business prospectus.

Discounted cash flow meaning could be well defined in professional language, based on its usefulness, I’d call it problem-solving valuation approach. Let’s talk about what exactly Discounted cash flow meaning is. Keep scrolling…

What is the Discounted Cash Flow Formula?

discounted cash flow graphic image
image: DCF Formula

As we all know by now that discounted Cash Flow is a technique that tells you how much money you can spend today in order to get the desired return in the future.

Let’s understand this again, “It’s an estimate of how much cash you will receive from the business, based on the present value of all future cash flows. DCF is like the calculator you’ve had at school for the past decade but in a business context”.

When you understand this, you don’t have to have a business or financial degree to make smart investment decisions, whether you are going to invest in a startup, buying a company, or opening a new manufacturing unit, etc. However, you need a more professional approach for serious investment or business.

Discounted cash flow formula is calculated on the basis of future free cash flow to analyze the enterprise value.

Future free cash flow is discounted future cash flow discounted at the capital structure interest rate.

That is, future free cash flow is the sum of operating cash flows discounted at the capital structure interest rate and capital expenditures discounted at a weighted average cost of capital (WACC).

For small businesses, you would typically discount future cash flow by 50% and thus, future free cash flow is 50% less than the value of operating cash flows (e.g., debt repayment and new investment returns).

How Discounted Cash Flow Method Works

Discounted cash flow method analyzed your projected cash flows to determine what your asset will be worth in the future. If the price of the stock rises or falls, then the present value of future cash flows will go up or down, thus determining the value of the company.

The company has to have growth, and future cash flow to estimate the value.

When you are calculating the investment or for the business purpose, think like this scenario; You have a car showroom,

how many cars are you going to sell in the next 3 years?

What’s the revenue of your company in the next year?

What is the growth potential of your business?

Now, what is the future cash flow that you can expect in the next 5 years? Your business can generate INR 100 crores per year in revenue in 2018.

How much would you need to be paid each year, to obtain that same INR 100 crores in revenue?

Investors can take the decision whether the initial investment is worth it or not by finding the present value of future cash flow by DCF Formula with the use of discounted rate. The investment is thought to be good if the DCF value is higher than the current investment.

This is a difficult task to undertake, but it is not impossible. If you are an investor and decided to invest in a business, or acquiring a company. You’d probably want to know the worthiness of the investment you are going to make.

Alright, you can do this by estimating the ending value of the equipment, assets, all the investment, future cash flow. The investor will have to consider a discount rate for the Discounted Cash Flow Techniques.

The higher the risk profile of a company or investor, the higher their discount rate.

In case if you are not able to determine future cash flow, then you as an investor will have to rely on an alternative model for the valuation.

Please watch this short video to learn how to calculate discounted cash flow:

How to use discounted cash flow to determine if an investment is worth it

Example of Discounted Cash Flow Method

Discounted Cash Flow Formula:

discounted cash flow formula

Here;

CF stands for the Cash flow,

CF1 (1 is a single year),

CF2 (2 as two years),

CFn (n indicating for additional years), and

r= is the discount rate (WACC)

Let’s take an example to understand the DCF; You as an investor planning to invest 2 Lakh with a tenure of next 5 years. The company has 10% of WACC

The estimated cash flow for this company will be as following data:

YearsCash Flow of the company
130000
242000
355000
468000
575000

Now, We’ll Calculate Discounted Cash flow in Order to Find its DCF Value:

DCF= [30,000/(1+0.1)1]+[42,000/(1+0.1)2]+[55000/(1+0.1)3]+[68000/(1+0.1)4]+[75000/(1+0.1)5]

By solving the above DCF Formula, we’ll get DCF for each year as below table value:

YearsCash Flow of the CompanyDCF
13000027272.73
24200034710.75
35500041322.31
46800046444.91
57500046569.1

When calculating all these 5 years of DCF values, the total DCF Values will be 196319.8.

We’ll get an NVP (Net present value) of INR 3680.2 by Subtracting the total DCF value from the initial investment. The NVP is a positive number. So, if you are investing INR 2 Lakh, you may receive good returns.

Also Read: Startup Valuation Methods

Businesses Using Discounted Cash Flows

Various companies use this method of valuing their business.

The ones that mostly use this method of valuing their business are banks, but even if it’s not the banks, companies using this method are usually used to find investment opportunities.

If the company shows good performance and is valued higher than its peers, then the business is probably good. Forward P/E ratio The forward P/E ratio meaning is also a good valuation tool.

This means you’re projecting the company’s earnings to the future. This is a forward-looking valuation technique, which measures a company’s value based on its future earnings, or earnings in the past. This will give you a good estimate of the present value of the earnings.

Usually, a company’s profit and loss statement will show the cash flow generated by a business in a given period. By making an assumption of the future cash flows, it can help companies better calculate their value. Is value assessment using these methods accurate?

No. Value assessment methods are no panacea. By using them, companies lose out on a number of ways to calculate their worth.

Calculation method, and how to calculate it Investors have very high regard for many of the valuation methods. However, not all of these methods are always that accurate. They tend to be partial and rely on assumptions.