In finance, discounted cash flow (DCF) analysis is a method of valuing a project, company, or asset using the concepts of the time value of money. All future cash flows are estimated and discounted to give their present values (PVs) — the sum of all future cash flows, both incoming and outgoing, is the net present value (NPV), which is taken as the value or price of the cash flows in question.
Using DCF analysis to compute the NPV takes as input cash flows and a discount rate and gives as output a price; the opposite process — taking cash flows and a price and inferring a discount rate, is called the yield.
Discounted cash flow analysis is widely used in investment finance, real estate development, and corporate financial management.
Discount rate
The most widely used method of discounting is exponential discounting, which values future cash flows as "how much money would have to be invested currently, at a given rate of return, to yield the cash flow in future." Other methods of discounting, such as hyperbolic discounting, are studied in academia and said to reflect intuitive decision-making, but are not generally used in industry.
The discount rate used is generally the appropriate Weighted average cost of capital (WACC), that reflects the risk of the cashflows. The discount rate reflects two things:
- The time value of money (risk-free rate) – according to the theory of time preference, investors would rather have cash immediately than having to wait and must therefore be compensated by paying for the delay.
- A risk premium – reflects the extra return investors demand because they want to be compensated for the risk that the cash flow might not materialize after all.
An alternative to including the risk in the discount rate is to use the risk free rate, but multiply the future cash flows by the estimated probability that they will occur (the success rate). This method, widely used in drug development, is referred to as rNPV (risk-adjusted NPV), and similar methods are used to incorporate credit risk in the probability model of CDS valuation.
Oxera (2011) reviews the selection of a discount rate suitable for the assessment of new and emerging energy technologies.
Methods of appraisal of a company or project
This is necessarily a simple treatment of a complex subject: more detail is beyond the scope of this article.
For these valuation purposes, a number of different DCF methods are distinguished today, some of which are outlined below. The details are likely to vary depending on the capital structure of the company. However the assumptions used in the appraisal (especially the equity discount rate and the projection of the cash flows to be achieved) are likely to be at least as important as the precise model used.
Both the income stream selected and the associated cost of capital model determine the valuation result obtained with each method. This is one reason these valuation methods are formally referred to as the Discounted Future Economic Income methods.
- Equity-Approach
- Flows to equity approach (FTE)
Discount the cash flows available to the holders of equity capital, after allowing for cost of servicing debt capital
Advantages: Makes explicit allowance for the cost of debt capital
Disadvantages: Requires judgement on choice of discount rate
- Entity-Approach:
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- Adjusted present value approach (APV)
Discount the cash flows before allowing for the debt capital (but allowing for the tax relief obtained on the debt capital)
Advantages: Simpler to apply if a specific project is being valued which does not have earmarked debt capital finance
Disadvantages: Requires judgement on choice of discount rate; no explicit allowance for cost of debt capital, which may be much higher than a "risk-free" rate
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- Weighted average cost of capital approach (WACC)
Derive a weighted cost of the capital obtained from the various sources and use that discount rate to discount the cash flows from the project
Advantages: Overcomes the requirement for debt capital finance to be earmarked to particular projects
Disadvantages: Care must be exercised in the selection of the appropriate income stream. The net cash flow to total invested capital is the generally accepted choice.
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- Total cash flow approach (TCF)
This distinction illustrates that the Discounted Cash Flow method can be used to determine the value of various business ownership interests. These can include equity or debt holders.
Alternatively, the method can be used to value the company based on the value of total invested capital. In each case, the differences lie in the choice of the income stream and discount rate. For example, the net cash flow to total invested capital and WACC are appropriate when valuing a company based on the market value of all invested capital.
Shortcomings
Commercial banks have widely used discounted cash flow as a method of valuing commercial real estate construction projects. This practice has two substantial shortcomings. 1) The discount rate assumption relies on the market for competing investments at the time of the analysis, which would likely change, perhaps dramatically, over time, and 2) straight line assumptions about income increasing over ten years are generally based upon historic increases in market rent but never factors in the cyclical nature of many real estate markets. Most loans are made during boom real estate markets and these markets usually last fewer than ten years. Using DCF to analyze commercial real estate during any but the early years of a boom market will lead to overvaluation of the asset.
Discounted cash flow models are powerful, but they do have shortcomings. DCF is merely a mechanical valuation tool, which makes it subject to the principle "garbage in, garbage out". Small changes in inputs can result in large changes in the value of a company. Instead of trying to project the cash flows to infinity, terminal value techniques are often used. A simple annuity is used to estimate the terminal value past 10 years, for example. This is done because it is harder to come to a realistic estimate of the cash flows as time goes on involves calculating the period of time likely to recoup the initial outlay.