What Is Discounted Cash Flow?

Discounted cash flow is a technique for valuation to estimate the intrinsic value of the security as the present value of its expected Future Cash Flows. The method relies much on the concept of calculating the present value of expected future cash flows using a suitable discount rate.

The return from any investment includes a time value factor, and hence it needs to be adjusted by using the discounted cash flow method to arrive at the present value of the investment.

The time value of money is a very vital concept. The time value of money values a dollar today higher than tomorrow. To understand the logic, we must have a look at the concept in depth. When the investor invests money, he is rewarded with a return; however, this return is ploughed back to him after a span of time or the span of the investment.

Let’s look at an example. Suppose Mr. A has invested $1 million in the bank for a year at an interest rate of 3.0%. The bank will pay back his capital of $1 million with interest of $3,000 after one year. Now, this interest is a reward to the investor, and he demands the interest primarily due to three reasons. Firstly, it is because of bearing an uncertainty risk of receiving his returns on his investments (Includes Credit Risk). Secondly, he is sacrificing the use of his money today for using it on some future dates (Time Value) and finally, the worth of his investment today cannot be same as in future dates, due to inflation in the normal economic situation. Hence, the interest rate includes a risk premium, inflation premium and a premium for sacrificing the use of money today in future date which is referred to as time value.

It is precisely for the time value factor that we must use the discounted cash flow method to arrive at the worth of any investment today. Any financial assets ideally generate a series of cash flows over a period of time, which the investor will receive either through an annuity or one time, post the investment span also known as the terminal period of the investment. However, the value of the investments after a span of time cannot be equated merely to its worth today due to the above-mentioned factors such as inflation, credit risk, etc. Hence to factorize the time value of money, we use the DCF method.

‘Free Cash Flow to The Firm’ (FCFF) and ‘Free Cash Flow to Equity’ (FCFE) are two common methods that use discounted cash flow techniques to arrive future value at the current valuation of the company. In FCFF, the total free cash flows available to the company or firm are projected for future periods and discounted using the ‘Weighted Average Cost of Capital’ (WACC) to arrive at a present valuation. While the FCFE uses the free cash available to the equity holders after paying the external debt-holders and uses the ‘Required Rate of Return/Cost of equity’ (Ke) as the discount rate to arrive at the present values. Free Cash Flow to Firm can be calculated as Net Income + Depreciation & Amortization + Interest (1- tax rate) +/- Changes in Capex +/- Changes in Working Capital.

To perform a DCF, we must estimate the future cash flows and terminal value at the end of the explicit forecast period. The cash flows can be discounted using the interest rate which includes the risk-free rate in the economy with a market premium to compensate for the risk.

However, the discounted cash flow method has several disadvantages as well, including the assumptions of the discount rate, determining the growth rate of the future cash flows, etc. In spite of several disadvantages, it is a reliable method and used widely by the analysts in finance to arrive at the present value of investments.

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