Discounted Cash Flow (DCF) Denition | Investopedia

1. Unconventional Cash Flow

BREAKING DOWN 'Discounted Cash Flow (DCF)'

There are several variations when it comes to assigning values to cash ows and the discount rate in a DCF
analysis. But while the calculations involved are complex, the purpose of DCF analysis is simply to estimate
the money an investor would receive from an investment, adjusted for the time value of money.
The time value of money is the assumption that a dollar today is worth more than a dollar tomorrow. For
example, assuming 5% annual interest, $1.00 in a savings accountwill be worth $1.05 in a year. Due to the
symmetric property (if a=b, then b=a), we must consider $1.05 a year from now to be worth $1.00 today. When
it comes to assessing the future value of investments, it is common to use the weighted average cost of capital
(WACC) as the discount rate.
For a hypothetical Company X, we would apply DCF analysis by rst estimating the rm's future cash ow
growth. We would start by determining the company's trailing twelve month (ttm) free cash ow (FCF), equal to
that period's operating cash ow minus capital expenditures. Say that Company X's ttm FCF is $50 m. We
would compare this gure to previous years' cash ows in order to estimate a rate of growth. It is also
important to consider the source of this growth. Are sales increasing? Are costs declining? These factors will
inform assessments of the growth rate's sustainability.
Say that you estimate that Company X's cash ow will grow by 10% in the rst two years, then 5% in the
following three. After a few years, you may apply a long-term cash ow growth rate, representing an
assumption of annual growth from that point on. This value should probably not exceed the long-term growth
prospects of the overall economy by too much; we will say that Company X's is 3%. You will then calculate a
WACC; say it comes out to 8%. The terminal value, or long-term valuation the company's growth approaches,
is calculated using the Gordon Growth Model:
Terminal value = projected cash ow for nal year (1 + long-term growth rate) /(discount rate - long-term
growth rate)
Now you can estimate the cash ow for each period, including the the terminal value:
Year 1

= 50 * 1.10

55

Year 2

= 55 * 1.10

60.5

Year 3

= 60.5 * 1.05

63.53

Year 4

= 63.53 * 1.05

66.70

Year 5

= 66.70 * 1.05

70.04

Terminal value

= 70.04 (1.03) / (0.08 - 0.03)

1,442.75

Finally, to calculate Company X's discounted cash ow, you add each of these projected cash ows, adjusting
them for present value using the WACC:
DCFCompany X= (55 / 1.081) + (60.5 / 1.082) + (63.53 / 1.083) + (66.70 / 1.084) + (70.04 / 1.085) + (1,442.75 /
1.085) =1231.83
$1.23 b is our estimate of Company X's present enterprise value. If the company has net debt, this needs to be
subtracted, as equity holders' claims to a company's assets are subordinate to bondholders'. The result is an
estimate of the company's fair equity value. If we divide that by the number of shares outstandingsay 10 m
we have a fair equity value per share of $123.18, which we can compare with the market price of the stock. If
our estimate is higher than the current stock price, we might consider Company X a good investment.
Discounted cash ow models are powerful, but they are only as good as their imports. As the axiom goes,
"garbage in, garbage out". Small changes in inputs can result in large changes in the estimated value of a
company, and every assumption has the potential to erode the estimate's accuracy.