When a company faces big decisions like buying new equipment or choosing between making products in-house or outsourcing, it is important to weigh the costs and benefits of each option. But here is something many forget, money today is not worth the same as money in the future. Hence, smart business decisions are backed by using the discounted cash flow (DCF) method. It helps in figuring out the real value of future cash flow in today’s terms. Do you know how it works and why it matters in making the right business choices? Read on to learn more about DCF and how it supports better decision-making.
Discounted Cash Flow (DCF) is a financial method used to estimate the value of an investment based on the money it is expected to generate in the future. It is widely used by businesses, investors and other stakeholders to make important financial decisions. The basic idea behind DCF is that the value of money changes over time. The value of Rs. 1,00,000 today is worth more than Rs. 1,00,000 received five years later. This is on account of various factors like inflation, which leads to the decay of money over time. In the DCF method, all future cash flows expected from a project or investment are adjusted using a discount rate, which reflects factors like inflation, interest rates, and investment risks. This gives the actual or the ‘present value’ of the future cash flows. This present value is then used to evaluate the decisions, where if the present value is higher than the cost of the investment, it may be considered a profitable choice. DCF helps individuals and businesses make smarter financial decisions by showing the true worth of future income in today’s terms.
Discounted cash flow is an important tool of analysis in the fundamental analysis of a company. This tool helps evaluate and select the most optimal or profitable option for a company rather than relying on face value or a sales pitch. The importance of DCF for businesses and investors can be explained below.
Shows True Value of Investment - DCF helps in finding the real worth of a business, project, or investment by calculating the present value of future cash flows or the worth of future earnings in today’s terms.
Helps in Better Decision-Making - DCF helps in informed decision-making as it gives a clear picture of the absolute returns from an investment, thereby highlighting whether an investment is worth the money being spent today.
Considers Time Value of Money - DCF works on the premise that money today is more valuable than the same amount in the future, due to inflation and earning potential (opportunity cost). This helps in the better use or allocation of resources for optimum results.
Useful for Comparing Options - Businesses can use DCF to compare different projects (like building a new factory or outsourcing work) based on hard facts and numbers to choose the one with better long-term returns.
Reduces Financial Risk - Investors can avoid risky decisions by calculating the present value of future cash flows and thus, invest in projects that are more likely to succeed.
Works for Any Industry - DCF can be applied in any field, whether it is a small business or a large company, as well as across any sector like real estate, manufacturing, IT services, etc.
Supports Long-Term Planning - DCF helps businesses look beyond short-term profits and plan for sustainable, long-term growth.
Terminal Value is the estimated value of a business or project at the end of a forecast period when future cash flows are expected to grow at a steady rate. To put it simply, we usually forecast cash flows for 5 to 10 years when using the Discounted Cash Flow (DCF) method. However, businesses do not stop after that and can continue to operate and earn money, in some cases, for perpetuity. Thus, in such cases, the terminal value is used to capture the worth of all future cash flows beyond the forecast period in one single number. This enables companies and other stakeholders to understand the long-term value of the project and not just the first few years.
The terminal value can be calculated using two methods, as explained below.
This method assumes that the cash flows for the business will continue for perpetuity at a constant rate forever. The formula to calculate the terminal value is,
Terminal Value = [CF * (1 + g)] / r - g
Where,
CF = Cash Flow in the last forecasted year
g = Growth rate of cash flows
r = Discounted rate (expected rate of return)
This uses a financial metric like EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortisation) and multiplies it by an industry-standard number (called a multiple).
The formula to calculate terminal value in this method is,
Terminal Value = EBITDA in the final year * Exit Multiple
DCF is used as a tool to evaluate the profitability or the financial viability of a project or a capital budgeting decision. The steps to calculate the discounted cash flows for a project and the interpretation are explained below.
Forecast the Future Cash Flows - Estimate the money (cash inflows) the business or project is expected to earn each year for the specified period under consideration. These are called projected free cash flows.
Choose a Discount Rate - Select a rate to adjust future cash flows to the current value. This is usually the expected rate of return or cost of capital or the weighted average cost of capital, which is often considered to be the most optimal measure to calculate DCF. It reflects the risk and time value of money.
Calculate the Present Value of Each Year’s Cash Flow - The next step is to calculate the present value of future cash flows using the following formula.
Present Value = Cash flow / (1+r) n
Where,
r = Discounting Rate
n = number of years
Add the Present Values of All Years - Add all the discounted values of cash flows from the previous step. This gives the present value of the forecast period.
Calculate the Terminal Value - Estimate the value of the business beyond the forecast period using a method like the Gordon Growth Model (explained earlier). Then, discount it to present value using the same formula.
Add the Terminal Value to the Total Present Value - Now, add the present value of the terminal value to the total from the previous step. This gives you the total DCF value.
Compare with the Current Investment Cost - Finally, compare the DCF value to the cost of investment today.
If the DCF value is higher, the investment is likely profitable.
If it is lower, it may not be a good idea.
Company A is considering a project requiring an investment of Rs. 25,00,000 with the expected cash flows over the next 3 years as follows,
Year 1 = Rs. 1,00,000
Year 2 = Rs. 1,20,000
Year 3 onwards = Rs. 1,50,000
The business expects the project to grow steadily at 5%, and the discounting rate to be considered is 10%.
The DCF for this project and its interpretation are explained below.
Step 1 - Calculating the present value of expected cash flows
Step 2 - Calculating the Terminal Value using the Gordon Growth Model
Terminal Value = Year 3 cash flow * (1+g) / (r-g)
Terminal Value = 150000 * (1+0.05) / (0.10 - 0.05) = 157500 / 0.05 = Rs. 31,50,000
Step 3 - Discounting Terminal Value to Present Value
PV of Terminal Value = 3150000 / (1+0.10)³ = 23,66,641.62 ≈ Rs. 23,66,642
Step 4 - Calculating Total DCF and Comparing it to Initial Investment
Total DCF = Total PV of Cash Flows + PV of Terminal Value
Total DCF = 302679 + 2366642 = Rs. 26,69,321
Initial Investment = Rs. 25,00,000
Interpretation - The Project is a financially viable investment and profitable, as the discounted cash flows from the project are higher than the initial investment.
Net Present Value (NPV) is a financial method used to determine whether an investment or project will be profitable after considering the time value of money. It compares the value of money expected to be received in the future with the amount invested today. Since money today is more valuable than the same amount in the future, future cash flows are discounted to find their present value. NPV is calculated by subtracting the initial investment cost from the total present value of all future cash flows. If the NPV is positive, it implies that the project is likely to earn more than it costs, while if it is negative, the project is not financially viable.
NPV is a key part and the extension of the discounted cash flow model to evaluate a project or a capital budgeting decision. NPV is a trusted and widely used tool for making smart long-term investment decisions, as it tells whether the project is financially beneficial or not.
The DCF method is a popular tool used by businesses across the world to make strategic decisions. However, it is not free from a few limitations that also need to be considered while using this model. Here is a brief analysis of the same.
Sensitive to Assumptions - Small changes in discount rate, growth rate or cash flows can give very different results.
Difficult to Predict Future Cash Flows - Estimating future earnings accurately is difficult, especially in uncertain markets, which can make them less reliable leading to misguided decision making.
Ignores Qualitative Factors - DCF only looks at hard numbers and does not focus on other material factors like brand value, market trends, or management quality which are also vital in decision making.
Can be Complex - DCF Model can be a complex model, especially small businesses where data collection and calculation may be tricky without expert help.
The discounted cash flow model is an integral part of the decision-making process as it allows users to take effective business decisions based on a clear analysis. While it does not address the qualitative factors that are involved in the decision-making process, it can show the viability and the effectiveness of the option at hand for comparison. Relying on DCF is thus one of the most trusted ways to make smart business decisions.
Marisha Bhatt is a financial content writer @TrueData.
She writes with the sole aim of simplifying complex financial concepts and jargon while attempting to clarify technical and fundamental analysis concepts of the stock markets. The ultimate goal is to spread vital knowledge and benefit the maximum audience. Her Chartered Accountant background acts as the knowledge base to help clarify crucial concepts and create a sound investment portfolio.
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