Discounted Cash Flow Analysis (“DCF”)

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What It Means

A Discounted Cash Flow Analysis, also called a DCF for short, is a common method of valuation to determine the present value of a future series of cash flows.

A DCF is calculated as follows:

The resulting present value using the formula above is compared against the net upfront cost of undertaking the project. If the value of the DCF calculation exceeds the cost of undertaking the project, then the opportunity should be considered.

Discounted Cash Flow Analysis (“DCF”) - CALCULATOR

Why It’s Important

Discounted Cash Flow Analyses are a useful tool to estimate the value of businesses. However, like all Business Valuation methods, there are limitations to when they should be applied. The Discount Rate chosen for the analysis can have a significant impact on the calculation of the present value and should reflect the risk of the investment and the company’s cost of capital. If a project is particularly complicated or if expected future cash flows cannot reasonably be calculated, then an alternate method should be used in place of or in conjunction with DCF.

Example

A company has an opportunity to invest in a project that will cost $12,000,000 up front. The company values projects using a Discount Rate of 10% based on their cost of capital (debt and equity). The company reasonably expects the project to last 5 years and return the following cash flows:

Thus, the resulting DCF formula would be:

To calculate the formula above in Excel, simply copy and past the following formula into a cell: =NPV(10%,500000,1000000,2000000,4000000,8000000)

As you can see from the calculations above, even though the project is expected to return more cash ($15.5 million) over the 5 year period than its up front cost ($12 million), the present value of those future cash flows ($10.5 million) is still far less than the up front cost. In this scenario, the company should decline taking on the project.

Note that if the Discount Rate was lower or if the expected resulting cash flows were higher in the first few years, the present value may be high enough to consider taking on the project.

Related Terms

• Asset-Based Valuation

• Business Valuation

• Compound Annual Growth Rate (“CAGR”)

• Discount Rate

• EBITDA Multiple

• Free Cash Flow

• Multiple

• Pro Forma

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