What is Discounted Cash Flow Analysis?
Discounted cash flow (DCF) analysis is the process of calculating the present value of an investment's future cash flows in order to arrive at a current fair value estimate for the investment.
Discounted Cash Flow Formula
The formula for discounted cash flow analysis is:
DCF = CF1/(1+r)1 + CF2/(1+r)2 + CF3/(1+r)3 ...+ CFn/(1+r)n
CF1 = cash flow in period 1
CF2 = cash flow in period 2
CF3 = cash flow in period 3
CFn = cash flow in period n
r = discount rate (also referred to as the required rate of return)
To determine a fair value estimate for a stock, first project the amount of operating cash flow the company is likely to produce in the years ahead. Most people estimate the cash flows for five or ten years in the future because it is nearly impossible to make a realistic estimate of cash flows for any lengthier amount of time. From there, determine how much those future cash flows are worth in today's dollars by discounting them back to the present at a rate sufficient to compensate investors for the risk taken. Finally, divide that figure by the total number of fully diluted shares outstanding to arrive at a per-share fair value estimate.
Because GAAP earnings are subject to manipulation and can be distorted by depreciation, goodwill write-downs, and a host of additional non-cash charges, many analysts believe a company's cash flows are a much better gauge of the value of its stock than its net income. Of course, in the real world, there is no guarantee that a company can deliver on its cash flow projections. As such, the riskier the company, the larger return investors demand.
It is important to note the three most influential components of DCF are time, expected rate of return, and the size of the cash flows each period. The further away a cash flow is, the less it is worth today. The higher an investor's expected rate of return, the less a future cash flow is worth today. The higher a cash flow is in any period, the more it is worth today. Small changes in these components can have significant effects, meaning that a DCF analysis is only as good as its assumptions.
Why DCF Analysis Matters
There are many ways to calculate what an investment is really worth today. For example, many investors rely on ratios such as price/book value, price/earnings, price/cash flow, etc. To be sure, such traditional valuation metrics can be useful, but they only tell part of the story.
DCF analysis is one of the most fundamental and pervasive concepts in finance, and one of its biggest advantages is that it accounts for the fact that money we receive today can be invested today, while money we have to wait for cannot. In other words, DCF accounts for the time value of money. As such, it provides an estimate of what we should spend today (e.g., what price we should pay) to have an investment worth a certain amount of money at a specific point in the future.