When making a decision about whether or not to invest in a particle venture or market, it can be very useful to consider its future performance. The discounted cash flow (DCF) is a valuation approach used to find an investment’s value by considering the cash flows expected in the future. Its full meaning, applications, and limitations are all discussed here.
Full Definition: Discounted Cash Flow (DCF)
There are many different valuation methods and financial models used to find out how much an investment is worth. The discounted cash flow method is among these. It is used to find the value of an investment based on its future earning potential. Put another way, the discounted cash flow is the present value of or expected future cash flows.
You can also look at the DCF financial model as an estimate of a company’s intrinsic value. This is a valuation based on its ability to generate cash flows. To make the determination make more sense, the discounted cash flow valuation is often compared to the current market value. If the former is greater than the latter, then the investment might be potentially profitable. The DCF determination could be a crucial determining criterion in a wide range of scenarios.
Applications of the DCF
Where might you apply the discounted cash flow evaluation? Whenever an investor is deciding whether to go into a particular venture, it is important to do a full assessment of the return on investment (ROI) they can expect.
The investment can be anything from a company, a new business venture, a stock or bond, the cryptocurrency market, real estate, or opening a new business branch. Individuals, businesses, and venture capitalists are all examples of investors who might want to use the DCF method before proceeding.
The purpose of any investment is to yield some kind of returns as soon as possible and as long as possible, depending on the nature of the undertaking. If you can determine that a particular investment is only going to be profitable for a short time after which it is going to become a liability with a net loss at disposal, you might think twice.
With the discounted cash flow method, you can make your best evaluation of which investment is worthwhile. No valuation method is foolproof, however, but the DCF method can give you a great starting point. Some of the limitations of this method are looked into a little later.
Calculating the DCF
There is a defined formula for determining the discounted cash flow of a potential investment opportunity. The DCF formula can be stated as follows:
The DCF value is given by the sum of the cash flow in each period divided by 1 + discount rate to the power of the period number. Numerically, this formula is calculated as follows:
DCF = (CF/(1+r)^1) + (CF/(1+r)^2) + (CF/(1+r)^3) + … + (CF/(1+r)^n)
While the formula may appear complex at first, each of the terms can be explained and simplified.
- “CF” is the cash flow in the period. See the definition of the period time frame below. Cash flow is defined as the net cash payment that you get as an investor in a specific period.
- The “n” in the above formula represents the period number. When talking about cash flow, it must be assigned to a specific time frame. The periods in this case can be months, quarters, or years, depending on what works best in the scenario.
- The “r” in the discounted cash flow formula represents the discount rate or interest rate. When evaluating a potential investment in a firm, the weighted average cost of capital (WACC) is commonly used as the discount rate. The WACC gives a value for the investors’ expected rate of return when investing in a company. When the investment is a bond, then “r” represents the interest rate on this bond.
As you can see, various pieces of financial data must be put together to calculate the discounted cash flow value. The better the numbers, the best the valuation is going to be. The DCF value can be compared to what the investment is currently selling for to see if it is a worthwhile opportunity. There are some limitations with this method, and these are discussed next.
Possible Limitations of this Valuation Method
Any financial model of evaluating an investment relies on estimates and different pieces of data. There is, therefore, no flawless approach, but the more robust the method, the better the values it can produce. The discounted cash flow method is widely used because it gives a reasonable way for investors to compare the value of their potential investments with the current market value of the company, stock, bond, or property.
There are a few limitations of the DCF financial model that are worth noting. The main drawback of this approach is that it is heavily dependent on estimates about future cash flows. It can be very difficult to estimate what an investment might yield in the future because there are many unforeseen factors that could impact its value. These include prevailing market conditions and changes in technology, relevant tax laws, and other regulations.
The better the estimates, the best the DCF valuation. While historical data and numbers from comparable investments can be very useful, there’s no real way to determine what the real cash flows of investment are going to be a year or more down the line.
Another very important factor in the discounted cash flow formula is the discount rate used. The choice of this rate is based on some assumptions, so it is best to get advice from experts to get the best rate value to use for each potential investment.
Before an investor puts money into a new venture, be it a large stake in a startup, a bond, shares, or any other investment, they must do a full assessment. While there is no way to be sure about how profitable a venture is going to be, the discounted cash flow methods provide a good basis to evaluate an investment.