DCF (Discounted Cash Flow)

What is Discounted Cash Flow (DCF)?

Discounted Cash Flow (DCF) is a form of financial valuation that computes the present value of an investment, project, or a company using expected future cash flows. DCF allows investors and companies to factor in the time value of money in making their investment decisions on whether or not to pursue it.

Major Components of DCF

• Cash Flows: The anticipated future inflows and outflows of cash.
• Discount Rate: It captures the risk and opportunity cost of capital, generally measured by WACC or the required rate of return.
• Time Period: This is the length of time at which cash flows are expected to occur.

Discounted Cash Flow (DCF) Formula

DCF Formula = ∑ {Cash Flow/(1+r)^t}

Cash Flow = Cash flow in year 𝑡
r = Discount rate
t = Time period

How DCF Works?

• Estimate Future Cash Flows: Anticipate cash flows the asset is going to create over a specified period.
• Determine the Discount Rate: Select a suitable rate given the risk profile and market conditions
• Calculate Present Value: Discount every cash flow to its present value using the formula
• Add Up the Values: Sum all the discounted cash flows to derive the total present value

Applications of DCF

1. Company Valuations: Very popular in mergers, acquisitions, and investment analysis.
2. Project Evaluation: Aids in determining whether long-term projects are profitable.
3. Investment Selection: Helps investors compare potential returns from various investment opportunities.

Advantages of DCF

1. In-Depth Analysis: Considers all future cash flows and the time value of money.
2. Flexibility: It is adaptable to a variety of assets and projects.
3. Fundamentals Emphasis: Intrinsic value rather than market trend is emphasized.

Limitations of DCF

1. Dependency on Assumptions: Highly sensitive to proper estimates of cash flows and discount rates.
2. Complexity: Complex need for detailed financial forecasting and a good understanding of the business.
3. Uncertainty: There is uncertainty in projecting long-term cash flows, which may go wrong.

Example of DCF in Practice

Assume that a company is expecting cash flows of ₹1,00,000 every year for the next 5 years. The discount rate is 10%. DCF would calculate the present value of each year's cash flow by discounting it back to its present value and summing them up to determine the worth of the investment today.

**Why DCF Matters?

DCF is a cornerstone of financial analysis, offering a robust framework for evaluating investment opportunities. It is particularly valued for its ability to account for the time value of money, making it a reliable tool for long-term financial planning and decision-making.