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# How to discount cash flow

Eric is currently a duly licensed Independent Insurance Broker licensed in Life, Health, Property, and Casualty insurance. He has worked more than 13 years in both public and private accounting jobs and more than four years licensed as an insurance producer. His background in tax accounting has served as a solid base supporting his current book of business.

Discounted free cash flow for the firm (FCFF) should be equal to all of the cash inflows and outflows, adjusted to present value by an appropriate interest rate, that the firm can be expected to bring in during its lifetime. It’s a form of time value analysis – how much an investor would pay today to have the rights to all future cash flow.

Free cash flows aren’t a readily available figure. Financial analysts have to interpret and calculate free cash flows independently. FCFF is distinct from free cash flow to equity, which does not account for bond creditors and preferred shareholders.

The short definition of FCFF is the cash flow available to all capital contributors after the firm pays all operating expenses, taxes and other costs of production.

To discount cash flow properly, you first need to be familiar with how to calculate the smaller components of the formula. The most important of these is the weighted average cost of capital (WACC) and the FCFF.

## Weighted Average Cost of Capital

Firms rely on the WACC to estimate the weighted cost of all sources of capital. It’s a way to allow managers to see how efficiently they finance operations. The formula for WACC can be written as:

## Free Cash Flow to the Firm

Several competing formulas exist for FCFF. A relatively simple version starts with earnings before interest, taxes and depreciation. It can be written as:

## Simple Approach to Discounted FCFF

One simple definition of the value of a firm – and one taught in CFA courses – is equal to the endless stream of free cash flows discounted by WACC. However, much depends on the estimated growth of the firm and whether that growth will be stable.

A single-stage, steady-growth estimation of discounted FCFF can be expressed this way:

Multistage models are considerably more complex and best performed by those comfortable with calculus.

## Forecasting Future Cash Flows

Predicting future growth and net cash flows is an inexact science at best. There are two common approaches in the financial literature: applying historical cash flow and predicting changes in the underlying components of cash flow.

It’s easy to use the historical method. If firm fundamentals are solid and not expected to change in the foreseeable future, analysts can apply the historical free cash flow rate.

The underlying components method isn’t as easy. Revenue growth is matched to the expected returns and costs of future capital expenditures, which includes fixed capital replacement and expansion, any depreciation and changes in working capital.

Do not confuse physical fixed capital, such as machines and factories, with capital financing from debt and equity.

## When You’re Looking at a Company’s Value, Cash Flow Is King

Evgeniia Siiankovskaia / Getty Images

Before investing in a company, you need to look at a few crucial factors. Many models exist to evaluate a company’s financial health and calculate estimated returns to reach an objective share price. One great way to do it is by measuring the company’s cash flow. This means looking at how much money a company has at the end of the year, compared to the beginning of the year.

## What Is the Discounted Cash Flow Model?

The discounted cash flow model (DCF) is one common way to value an entire company. When you use the DCF to value a company, you are able to decide how much its shares of stock should cost.

DCF is considered an “absolute value” model. It uses objective financial data to evaluate a company, instead of comparisons to other firms. The dividend discount model (DDM) is another absolute value model that is widely accepted, though it may not be appropriate for certain companies.

## The DCF Model Formula

The DCF formula is more complex than other models, including the dividend discount model. The formula is:

Present value = [CF1 / (1+k)] + [CF2 / (1+k) 2 ] + . [TCF / (k-g)] / (1+k) n-1 ]

That looks fairly tricky, but let’s define the terms:

• CF1: The expected cash flow in year one
• CF2: The expected cash flow in year two
• TCF: The “terminal cash flow,” or expected cash flow overall. This is usually an estimate, as calculating anything beyond five years or so is guesswork
• k: The discount rate, also known as the required rate of return
• g: The expected growth rate
• n: The number of years included in the model

There is a simpler way of looking at this, however.

Let’s look at a small fictional company, Dinosaurs Unlimited. Suppose we’re calculating for five years out, the discount rate is 10%, and the growth rate is 5%.

Note: There are two different ways of calculating terminal cash flow. For simplicity, let’s assume the terminal value is three times the value of the fifth year.

If we assume that Dinosaurs Unlimited has a cash flow of \$1 million now, its discounted cash flow after a year would be \$909,000. We arrive at that number by assuming a discount rate of 10%.

In the years that follow, cash flow is increasing by 5%. Thus, new discounted cash flow figures over a five-year period are:

Year 2: \$867,700
Year 3: \$828,300
Year 4: \$792,800
Year 5: \$754,900

We noted above that the terminal value will be three times that of the value in the fifth year, so that comes to \$2.265 million. Add all these figures, and you come to \$6.41 million. Based on this analysis, that’s the value of Dinosaurs Unlimited. But what if Dinosaurs Unlimited were a publicly traded company? We could determine whether its share price was fair, too expensive, or a potential bargain.

Let’s assume that Dinosaurs Unlimited is trading at \$10 per share, and there are 500,000 shares outstanding. That represents a market capitalization of \$5 million. Thus, a \$10 share price is on the low side. If you are an investor, you might be willing to pay nearly \$13 per share, based on the value stemming from the DCF.

## Pros and Cons of the DCF Model

Accounting scandals in recent years have placed a new importance on cash flow as a metric for determining proper valuations.

Cash flow, however, can be misleading in some instances. If a company sells a lot of its assets, for example, it may have positive cash flow but may actually be worthless without them. It’s also crucial to note whether a company is sitting on piles of cash or reinvesting back into the company.

Cash flow is generally harder to manipulate in earnings reports than are profits and revenue.

Like other models, the discounted cash flow model is only as good as the information entered, and that can be a problem if you don’t have access to accurate cash flow figures. It’s also harder to calculate than other metrics, such as those that simply divide the share price by earnings. If you are willing to do the work, this can be a good way to decide whether it’s a sound idea to invest in a company.

## What is DCF Formula (Discounted Cash Flow)?

Discounted Cash Flow (DCF) formula is an Income-based valuation approach and helps in determining the fair value of a business or security by discounting the future expected cash flows. Under this method, the expected future cash flows are projected up to the life of the business or asset in question, and the said cash flows are discounted by a rate called the Discount Rate to arrive at the Present Value.

• CFt = cash flowCash FlowCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment.read more in period t
• R = appropriate discount rate given the riskiness of the cash flows
• t = life of the asset, which is valued.

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For eg:
Source: DCF Formula (Discounted Cash Flow) (wallstreetmojo.com)

The terminal value of a business is calculated using the Perpetual growth rate method or Exit Multiple Method.

Under the Perpetual Growth Rate Method, the terminal value is calculated as

• TVn Terminal Value at the end of the specified period
• CFn represents the cash flow of the last specified period
• g is the growth rate
• WACC is the Weighted Average Cost of Capital.

### FCFF and FCFE used in DCF Formula Calculation

Let’s understand both and then try to find the relation between the two with an example:

#### #1 – Free Cashflow to Firm (FCFF)

Under this DCF calculation approach, the entire value of the business, which includes besides equities, the other claim holders in the firm as well (debt holders, etc.). The cash flows for the projected period under FCFF are computed as under

These Cash flows calculated above are discounted by the Weighted Average Cost of Capital (WACC), which is the cost of the different components of financing used by the firm, weighted by their market value proportions.

Finally, all the numbers are added to arrive at the enterprise value as under:

#### #2 – Free Cashflow to Equity (FCFE)

Under this DCF Calculation method, the value of the equity stake of the business is calculated. It is obtained by discounting the expected cash flows to equity, i.e., residual cash flows after meeting all expenses, tax obligations, and interest and principal payments Principal Payments The principle amount is a significant portion of the total loan amount. Aside from monthly installments, when a borrower pays a part of the principal amount, the loan’s original amount is directly reduced. read more . The cash flows for the projected period under FCFE are calculated as under:

The above cash flows for the specified period are discounted at the cost of equity (Ke), which was discussed above, and then the Terminal Value is added (discussed above) to arrive at the Equity Value.

### Example of DCF Formula (with Excel Template)

The following data is used for the calculation of Value of Firm and Value of Equity using the DCF Formula.

Also, assume that cash at hand is \$100.

#### Valuation using FCFF Approach

First, we have calculated the Value of the Firm using the DCF Formula as follows.

Cost of Debt

Cost of Debt is 5%

WACC

• WACC = 13.625% (\$1073/\$1873)+5%( \$800/\$1873)
• = 9.94%

Calculation of Value of Firm using DCF Formula

Value of Firm= PV of the (CF1, CF2…CFn) + PV of the TVn

Value of Firm using DCF Formula

Thus Value of the Firm using a Discounted Cash flow formula is \$1873.

• Value of Equity = Value of the Firm – Outstanding Debt + Cash
• Value of Equity = \$1873 – \$800+ \$100
• Value of Equity = \$1,173

#### Valuation using FCFE Approach

Let us now apply DCF Formula to calculate the value of equity using the FCFE approach

Value of Equity= PV of the (CF1, CF2…CFn) + PV of the TVn

Here Free Cash flow to Equity (FCFE) is discounted using the Cost of Equity.

• Value of Equity= (\$50/1.13625) + (\$60/1.13625^2) + (\$68/1.13625^3) + (\$76.2/1.13625^4) + (<\$83.49+\$1603>/1.13625^5)

Value of Equity using DCF Formula

Thus Value of Equity using a Discounted Cash flow (DCF) formula is \$1073.

Total Value of Equity = Value of Equity using DCF Formula + Cash

• \$1073 + \$100 = \$1,173

### Conclusion

The discounted Cash flow (DCF) formula is a very important business valuation tool which finds its utility and application in the valuation of an entire business for mergers acquisition purpose. It is equally important in the valuation of Greenfield Investments. It is also an important tool in the valuation of securities such as Equity or a Bond or any other income generating asset whose cash flows can be estimated or modeled.

### Recommended Articles

This article has been a guide to DCF Formula. Here we discuss how to calculate the Fair Value of Firm and Equity using the Discounted Cash Flow Formula along with the practical examples and downloadable excel sheet. You can learn more about accounting from the following articles –

## positive minds live positive lives

We covered some accounting basics in the last post, looking specifically at the three financial statements: the balance sheet, income statement and cash flow statement. In today’s post we look at a common technique used to value a company, called a discounted cash flow (DCF) model, by projecting all future cash flows. We will break this method down into three stages:

1. Short term free cash flow projections
The first stage of a DCF is to forecast the free cash flows (FCF) to the business over the next few years. The shorter the forecasting period, the more accurate the DCF model will be. It is easier to forecast short term growth as we can be more certain about performance in the near future, compared to 10+ years into the future. Using the financial statements covered in the last post, the free cash flow for each period is calculated by:
Free cash flow = EBIT(1-tax) + Depreciation + Amortisation – Capital Expenditure – Increase in net-working capital.

In this formula EBIT is the earnings before interest and tax, which is tax adjusted due to the corporate tax rate. The corporate tax rate varies from country to country, but most fall in the range of 10%-40%. Since depreciation and amortisation are non-cash expenses we add those to the tax-adjusted EBIT. The capital expenditure is subtracted from the tax adjusted EBIT since these are costs that are necessary to run the firm. Similar to CapEx, any increase in net-working capital (NWC) is subtracted.
These free cash flows are projected out for a suitable number of periods (usually in the range 5-10 years). Many assumptions are needed to project this growth. The financial statements need to be analysed in detail here to ensure the projected free cash flows are accurate and a fair prediction of future growth.

Stage 2: Free cash flows to perpetuity (Terminal Value)
In stage 1, the FCFs were forecast out to a time in the near future (5-10 years). This is not the whole picture. We need to next account for all future cash flows that may go well beyond five years into the future. There are a number of ways to do this. In my post looking at the equity markets, I showed how the DDM technique can be applied in perpetuity, using the infinite geometric sum. The same technique can be applied when forecasting FCFs – this technique is called the Gordon growth model. Using the infinite geometric sum covered in the equity markets blog post, the terminal value (TV) of the FCFs is found to be

where is the predicted free cash flow for the furthest year forecast from stage one (here we have taken 5 years). The growth rate is g and is assumed to be around GDP growth rate (or similar), and is the weighted-average cost of capital.

A more simple method, and the one most commonly used in industry, is the exit multiple method. This involves using some kind of exit multiple (based on research done by equity analysts which we won’t go into here) and multiplying it by the EBITDA or EBIT. EBITDA stands for earnings before interest, tax, depreciation and amortisation. The value of this product will give us a terminal value which is used to forecast the FCFs to perpetuity. This method is used more often since there has often been research done on the firm to give an accurate exit multiple. Sometimes another similar firm will have this data available which can be used for the exit multiple. To check the terminal value number is roughly correct, the Gordon growth method can be used as a quick-check. Though these figures will differ, they should be of the same order.

Stage 3: Discounting the free cash flows
Stage 1 and 2 gave us the free cash flows for the firm we are valuing. The final step is to discount these values at the appropriate rate. We use the weighted average cost of capital, . Again in a similar fashion to the DDM method, the market value of the firm is given by

where it is worth noting that the terminal value is discounted at the same rate as the final short-term FCF forecast from stage 1.

1. Stub period
The first free cash flow needs to be adjusted by a stub period. This is because, in the original formula, we assume that this cash flow includes a whole period (eg: 1 full year), whereas in reality we will be calculating this cash flow at some point during the year. This adjustment means that the denominator will become where x is the current day of the period.
2. Mid-Year Discount
Firms collect cash flows throughout the year, and so we need to adjust our discount period by half year periods, instead of whole years. If we do not adjust for this, the valuation estimation will be greatly inflated compared to the true value.

That sums up the DCF valuation method. We have now covered the DCF and DDM valuation methods. We will continue our discussion of valuation methods in the next post, where I will cover the method of comparables (multiples), as well as a brief comparison of the DCF and DDM techniques.

A few weeks ago, I was in a meeting with about 15 smart real estate and finance people, many of whom have Ivy League MBA’s. We spent about 20 minutes discussing and debating the use of Discount Rates and Cap Rates in analyzing real estate investments (click here to read about cap rates). Since there was some confusion among the group about how to select an appropriate discount rate, I’ve decided to write a post about it. Here goes.

### Discount Rate Basics

In commercial real estate, the discount rate is used in discounted cash flow analysis to compute a net present value. See a basic definition below:

Discount Rate – The discount rate is used in discounted cash flow analysis to compute the present value of future cash flows. The discount rate reflects the opportunity costs, inflation, and risks accompanying the passage of time.

There is not a one-size-fits-all approach to determining the appropriate discount rate. That is why our meeting went from a discussion to a lively debate. However, a general rule of thumb for selecting an appropriate discount rate is the following:

Small investors: Discount Rate = the investors’ required rate of return

Institutional investors: Discount Rate = Weighted Average Cost of Capital (WACC)

*WACC is defined as the weighted average of all capital sources used to finance an investment (i.e. debt & equity sources).

Using this approach, investors are able to ensure that their initial investment in the asset achieves their return objectives. Now that we have definitions and basics out of the way, lets dive into how discount rates are determined in practice and in theory.

### Discount Rates in Practice

Practically speaking, you can think of the discount rate as the expected rate of return, or IRR (without leverage). It can be thought of as the opportunity cost of making the investment. The opportunity cost, would be the cost related to the next best investment. In other words, the discount rate should equal the level of return that similar stabilized investments are currently yielding.

If we know that the cash-on-cash return for the next best investment (opportunity cost) is 8%, then we should use a discount rate of 8%.

Discount Rates are determined by our Level of Confidence

A discount rate is a representation of your level of confidence that future income streams will equal what you are projecting today. In other words, it is a measure of risk. A higher discount rate relative to a lower discount rate generally means that there is more risk associated with the investment opportunity. Therefore, we should discount future cashflows by a greater percentage because they are less likely to be realized. Conversely, if the investment is less risky, then theoretically, the discount rate should be lower on the discount rate spectrum. Therefore, the discount rate used when analyzing a stabilized class A apartment complex will be lower than the discount rate used when analyzing a ground-up shopping center development in a tertiary market.

The higher the Discount Rate, the greater the perceived risk

The lower the Discount Rate, the smaller the perceived risk

Keep in mind that the level of risk is a function of both the asset-level risk as well as the business plan risk. Asset risk is the product type, the market, the location etc. The business plan risk refers to the strategy behind the project. A ground-up development will have more business plan risk than a passive investment in a stabilized project.

Build-Up Method

Another way of thinking about a discount rate is through the Build-Up Method. This is a more academic approach than that of the opportunity cost approach. It is essentially a rate built by taking the risk free rate (US Treasury) and adding to it margins for the unique set of operating, market, and credit risks as well as a liquidity risk premium.

Discount rate = Risk Free Rate + Real Estate Risk Premium

To break the Build-up Method down even further, you can add the following factors of risk together to arrive at the appropriate discount rate:

+ Risk Free Rate

+ Expected economy-wide Inflation

+ Property specific risk premium associated with it’s NOI

+ Liquidity premium (relative to the 10-yr US Treasury Bond)

= Discount Rate

Real World Exampl

### Real World Examples

If you are acquiring an existing stabilized asset with credit tenants then you could use a discount rate of around 7%. If you are analyzing a speculative development, you discount rate should be in the high teens. In general, discount rates in real estate fall between 6-12%.

Selecting the appropriate discount rate is an inexact science. As such, I can’t tell you exactly what discount rate to use. If you use the general guidelines and approaches outlined in this article, you have everything you need to make an appropriate selection.

### Covid-19 Pandemic’s Impact on Discount Rates

Many private REITs and funds are reappraised on a consistent basis to determine their Net Asset Value (NAV). The net asset value of an asset, or portfolio of assets (at the fund level), is the gross asset value minus the debt. Many companies will get their properties, and the fund, appraised periodically to reset the NAV. This is typically on a quarterly basis, sometimes monthly. Due to the pandemic, and the uncertainty around retail, many retail property NAV appraisals have come in lower than before the pandemic. This is because some appraisers have increased the discount rate. It’s been a modest increase of about 25 bps, but it is enough to bring down the NAV which in turn could negatively impact investor returns. This is one example of how market conditions and uncertainty can influence the discount rate being used to value an asset.

Discounted cash flow or DCF is the method for estimating the current value of an investment by taking into account its future cash flows. It can be used to determine the estimated investment required to be made in order to receive predetermined returns.

The discounted cash flow method is based on the concept of the time value of money, which says that the money that an individual has now is worth more than the same amount in the future.

For example, Rs.1,000 will be worth more currently than 1 year later owing to interest accrual and inflation. If a person is seeking to invest Rs.1,000 now, he or she will want to know its return on investment and what its future valuation will be, which can be calculated through DCF.

## Where can the Discounted Cash Flow Method be Used?

DCF can be used to estimate the valuation of –

• Real estate
• Stocks
• Bonds
• Long-term assets
• Equipment

## What is the Formula for Calculating DCF?

The DCF formula is as follows –

In this formula –

For bonds, the cash flows are principal and dividend payments.

For businesses, it is the weighted average cost of capital (WACC). It is the rate which investors expect to receive on average from a firm for financing its assets. WACC includes the average cost of a firm’s working capital minus taxes.

Example –

Let’s assume that Mr. Shankar plans to make an investment of Rs.1 Lakh in business for a tenure of 5 years. The WACC of this business is 6%.

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or 0.05% (whichever is lower)

The estimated cash flows are mentioned below –

 Year Cash flow 1 Rs.20,000 2 Rs.23,000 3 Rs.30,000 4 Rs.37,000 5 Rs.45,000

Based on the formula –

Therefore, the DCF for each year will be –

 Year Cash flow Discounted cash flow 1 Rs.20,000 Rs.18,868 2 Rs.23,000 Rs.20,470 3 Rs.30,000 Rs.25,188 4 Rs.37,000 Rs.29,307 5 Rs.45,000 Rs.33,627

The total discounted cash flow valuation will be Rs.1,27,460. When subtracted from the initial investment of Rs.1 lakh, the net present value (NPV) will be Rs.27,460. As the NPV is a positive number, Mr. Shankar’s investment in the businesses will be lucrative.

However, if he had invested Rs.2 Lakh, he would have incurred a loss of Rs.72,540 as the NPV would have been negative.

## Calculating the Weighted Average Cost of Capital (WACC)

It may so happen that investors have to calculate the weighted average cost of capital (WACC) before finding DCF.

In such cases, they can use the following formula –

WACC = (E / V x Re) + [D / V x Rd x (1 – Tc)]

In this formula,

 E Market value of a business’ equity. D Market value of the business’ debt. Re Cost of equity V Total market value of the business’ financing. (E + D) Rd Cost of debt Tc Rate of corporate tax

Example –

Company ABC has shareholder equity of Rs.50 Lakh (E), and its long-term debt was Rs.10 Lakh (D) for the fiscal year 2019. Therefore, the total market value of ABC’s financing is Rs.60 Lakh (V = E + D).

Now, let’s assume that the cost of equity (Re) and the cost of debt (Rd) of ABC is 6.6% and 6.4%, respectively. The rate of corporate tax is 15%.

Using the formula –

WACC = (50 / 60 x 6.6%) + [10 / 60 x 6.4% x (1 + 15%)]

= 0.055 + (0.167 x 0.065 x 1.15)

Therefore, WACC = 6.7%, which shareholders of ABC are receiving on an average every year for financing its assets.

## What is the Terminal Value in DCF?

The terminal value in DCF analysis is the final causation at the end of the formula. It is the projected growth rate of cash flows for the years over and above the considered period.

There are two methods for calculating the terminal value –

• Exit multiple methods –In this method, a financial metric of a company (like EBITDA) is multiplied by a trading multiple (for e.g. Terminal value = EBITDA x 10).
• Perpetuity method – Terminal value = [FCWnx (1 + g)] / (WACC – g).Here, FCF is free cash flow and ‘g’ is the perpetual growth rate of FCF.

As projections in DCF in case of business go as far as 5 or 10 years, making a reliable estimate after that period can become challenging. Hence, the terminal value is used to forecast cash flow after that particular time frame.

When making a decision about whether or not to invest in a particle venture or market, it can be very useful to consider its future performance. The discounted cash flow (DCF) is a valuation approach used to find an investment’s value by considering the cash flows expected in the future. Its full meaning, applications, and limitations are all discussed here.

## Full Definition: Discounted Cash Flow (DCF)

There are many different valuation methods and financial models used to find out how much an investment is worth. The discounted cash flow method is among these. It is used to find the value of an investment based on its future earning potential. Put another way, the discounted cash flow is the present value of or expected future cash flows.

You can also look at the DCF financial model as an estimate of a company’s intrinsic value. This is a valuation based on its ability to generate cash flows. To make the determination make more sense, the discounted cash flow valuation is often compared to the current market value. If the former is greater than the latter, then the investment might be potentially profitable. The DCF determination could be a crucial determining criterion in a wide range of scenarios.

## Applications of the DCF

Where might you apply the discounted cash flow evaluation? Whenever an investor is deciding whether to go into a particular venture, it is important to do a full assessment of the return on investment (ROI) they can expect.

The investment can be anything from a company, a new business venture, a stock or bond, the cryptocurrency market, real estate, or opening a new business branch. Individuals, businesses, and venture capitalists are all examples of investors who might want to use the DCF method before proceeding.

The purpose of any investment is to yield some kind of returns as soon as possible and as long as possible, depending on the nature of the undertaking. If you can determine that a particular investment is only going to be profitable for a short time after which it is going to become a liability with a net loss at disposal, you might think twice.

With the discounted cash flow method, you can make your best evaluation of which investment is worthwhile. No valuation method is foolproof, however, but the DCF method can give you a great starting point. Some of the limitations of this method are looked into a little later.

## Calculating the DCF

There is a defined formula for determining the discounted cash flow of a potential investment opportunity. The DCF formula can be stated as follows:

The DCF value is given by the sum of the cash flow in each period divided by 1 + discount rate to the power of the period number. Numerically, this formula is calculated as follows:

DCF = (CF/(1+r)^1) + (CF/(1+r)^2) + (CF/(1+r)^3) + … + (CF/(1+r)^n)

While the formula may appear complex at first, each of the terms can be explained and simplified.

• “CF” is the cash flow in the period. See the definition of the period time frame below. Cash flow is defined as the net cash payment that you get as an investor in a specific period.
• The “n” in the above formula represents the period number. When talking about cash flow, it must be assigned to a specific time frame. The periods in this case can be months, quarters, or years, depending on what works best in the scenario.
• The “r” in the discounted cash flow formula represents the discount rate or interest rate. When evaluating a potential investment in a firm, the weighted average cost of capital (WACC) is commonly used as the discount rate. The WACC gives a value for the investors’ expected rate of return when investing in a company. When the investment is a bond, then “r” represents the interest rate on this bond.

As you can see, various pieces of financial data must be put together to calculate the discounted cash flow value. The better the numbers, the best the valuation is going to be. The DCF value can be compared to what the investment is currently selling for to see if it is a worthwhile opportunity. There are some limitations with this method, and these are discussed next.

## Possible Limitations of this Valuation Method

Any financial model of evaluating an investment relies on estimates and different pieces of data. There is, therefore, no flawless approach, but the more robust the method, the better the values it can produce. The discounted cash flow method is widely used because it gives a reasonable way for investors to compare the value of their potential investments with the current market value of the company, stock, bond, or property.

There are a few limitations of the DCF financial model that are worth noting. The main drawback of this approach is that it is heavily dependent on estimates about future cash flows. It can be very difficult to estimate what an investment might yield in the future because there are many unforeseen factors that could impact its value. These include prevailing market conditions and changes in technology, relevant tax laws, and other regulations.

The better the estimates, the best the DCF valuation. While historical data and numbers from comparable investments can be very useful, there’s no real way to determine what the real cash flows of investment are going to be a year or more down the line.

Another very important factor in the discounted cash flow formula is the discount rate used. The choice of this rate is based on some assumptions, so it is best to get advice from experts to get the best rate value to use for each potential investment.

## Conclusion

Before an investor puts money into a new venture, be it a large stake in a startup, a bond, shares, or any other investment, they must do a full assessment. While there is no way to be sure about how profitable a venture is going to be, the discounted cash flow methods provide a good basis to evaluate an investment.

Meta title: What Is the Discounted Cash Flow (DCF) Method?
Meta description: The discounted cash flow method (DCF) helps an investor assess what an investment is worth by looking at the expected future cash flow. Find out more here.

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As Ali Boone’s article titled Rental Property Numbers so Easy that You Can Calculate Them on Napkin pointed out, “In this industry, you must love the numbers. Love them like they are part of you. For good or for bad, ‘til death do you part, never leave the numbers.”

Knowing how to quickly analyze deals to ascertain their cash flow is the key skill set needed by an income oriented real estate investor. My goal with this article is to build on top of the great foundation laid by Ali to show you to how build out a Discount Cash Flow Analysis Model.

## What is a Discounted Cash Flow Model?

A discounted cash flow (DCF) analysis is a method of valuing an asset using the concepts of the time value of money. All future cash flows are estimated and discounted to give their present value (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. Simplifying that cumbersome definition is that DCF analysis helps determine the value of an item/asset/company based on discounting back to today the cash flow that this asset can produce during your target holding period.

## What You Need to Build a DCF Model?

You will need two things to build your very own DCF model:

1. You will need access to a spreadsheet program. I utilize Microsoft Excel but if you do not want to pay for that program then you get a great proxy of that program at Open Office or through Google Docs.
2. You are going to need data on the items that Ali wrote about in her past article relating to the income and the expense categories. So have those number handy and close by.

### How to Build your Own DCF Model?

Now that you have the two items needed to build your model. Lets start building this model from scratch:

Step I- Open a New Spreadsheet Document

Tip: Name and Save the spreadsheet upfront as the last thing you want to do is loose your work incase your close out or power goes from your laptop. It has happened to me so learn from my lessons.

Step II- There are two components to a DCF calculation: The Cash Flows and the Discount Rate.

Cash Flows: In our case will be net cash remaining after all expenses associated with the property are paid off so basically any cash flow that you as the equity investor will receive.

Discount Rate: The required rate of return that you demand on your money. Remember: we advised you to include this rate of return in your investment plan as well. It will all come together. So time to take that number of the out of the plan and input into your DCF model!

These two components when used together will help determine the Present Value (PV) of your next investment asset.

Open the blank spreadsheet and enter “years” in Cell A2 and the numbers 1-5 in cells B2:F2 to represent the year numbers for our worksheet as per the example below:

Next we are going to enter the first year Net Operating Income (NOI)

Assumption: The first year net cash flow is \$10,000; Enter that amount in cell B3.

The next part of a DCF Analysis is to project the growth of income and expense over the horizon of your holding period. For the sake of simplicity we will be using just the NOI t is normal to use 3% for income growth rate year over year but make sure that the growth rate is feasible within your rental market. Enter 3% in cell B5 and lets grow our cash flow by 3% each year. Enter the following formula

=B3*(1+\$B\$5) into Cell C3 to grow the cash flow by 3% from the prior year and then click the outside right part of the cell and drag it across the columns until F3.

Next we will put the labels Cash Flow and Discount Factor in cells A3:A4 respectively as per the example below:

Next, in cell B5 input the rate at which you wish to discount the future cash flow back to today’s dollars.

Discount Rate percentage can simply be what you want to make per annum or you can use the following formula as guide post in helping you ascertain the target risk-free rate:

Risk Free Rate (10 Year Treasury Rate)

+ Opportunity Cost (5 Year CD Rate or S&P500 Dividend Yield)

+ Liquidity Premium (Real Estate is a illiquid asset so charge a premium for the risk)

+ Investor Return Percentage (What is the annual return that you wish to make)

= Your Personalized Discount Rate Percentage

**My discount rate analysis is indicated in the excel snapshot below:

Next we need to calculate what is the Net Value of the asset’s future discounted cash flows. For that you use a formula called Net Present Value (NPV).

Net Present Value compares the value of a dollar today to the value of that same dollar in the future, taking inflation and returns into account. If the NPV of a prospective project is positive, it should be accepted.

You can use the formula below to both discount the cash flow and calculate the NPV value of your asset:

Lastly the enter the heading NPV into cell A6, then go to cell B6 and enter the formula shown above.

So was your NPV positive or negative?

In our example above the NPV was positive which means that the project should be accepted as it will produce positive cash flows based on your personalized discount rate. In addition, this analysis indicates that the value of \$53,092 of future cash flow is \$41,542 today. That is time value of money folks as a dollar tomorrow is worth less than a dollar today!

Disclaimer: This is a very basic DCF model that ignores capital repairs, income changes, expense changes. I wanted to put this post together to just help new investors get a good grab on what a DCF model is all about and how they can use the tool to make income investment decision.

Build your very own DCF model and analyze your future deals with ease.

## Learn how to estimate the future value of a business’ cash flows

What is DCF?

Discounted cash flow is a valuation method that finds the present value of discounted future cash flows using a discount rate. In a broad sense, it relies on the “time value of money” concept, which states that a dollar today is worth more than a dollar tomorrow (because the dollar today can be invested and can earn interest). DCF is used throughout the financial industry and can be used to value almost any cash-generating asset.

Why would you want to use it?

There are more steps that go into the calculation of DCF than for more simple metrics like price-earnings, price-book, dividend yield and so on. So why go to the trouble of doing it? DCF allows you to compare companies from different industries, or in different stages of the growth cycle, whereas comparables like price-earnings always need to be viewed in the context of the group the security is in. DCF allows you to consider two unrelated investments based purely on their ability to generate cash for shareholders.

What kind of assumptions go into it?

So how does one calculate DCF? Since we cannot predict the future, any estimate of cash flow must be just that – an estimate. However, there are a number of questions that we can ask to help guide us in this process. First, what has the company’s cash flow been like recently? Is it growing, shrinking or stable? What effect will revenue growth have on cash flow? Will the business’ costs scale with revenue, or does it benefit from operating leverage? What kind of moat does your company have? Are competitors gaining on it, or falling behind?

As you can see, an awful lot can go into these considerations, and it is the job of the security analyst to sort through what is and isn’t important. Once you have a reasonable estimate of future cash flows, you are ready to move on to the next step in the process – actually building a model.

Building the model

A dollar today is worth more than a dollar tomorrow. But by how much? This is where the discount rate comes in. The discount rate is the amount of interest you could be reasonably expected to earn on your investment today. If you have \$100 today and think that you could earn 5% annual interest on it, then in a year you will have \$105. A year after that, \$110.25.

What we need to figure out is how much money we need to have today so that we will have \$100 in a year’s time. To find this, we divide the future cash flow of \$100 by the amount it will be worth in a year. For example, \$100/\$105 = \$95.24. If you invested \$95.24 today at an annual interest rate of 5%, you would have \$100 in a year’s time. Ergo, a cash flow of \$100 in a year’s time is equivalent to a cash flow of \$95.24.

Stated generally, the formula for calculating DCF is as follows:

Present value of cash flow in year n = cash flow in year n/(1 + r)^n

Where “r” is the discount rate.

Let’s illustrate this with an example.

We have estimated that a business will generate a cash flow of \$5,000 in two year’s time. We estimate the annual discount rate to be 3%. The calculation is:

\$5000/(1 + 0.03)^2 = \$5000/(1.03)^2 = \$5000/1.0609 = \$4,712.98

The longer you have to wait and the higher the discount rate, the less valuable is the cash flow right now.

In this example, we have assumed the investor is applying a discount rate based on the risk-free return they think they can earn by parking their money elsewhere. This opportunity cost is known as the cost of capital. This is not the only way to calculate the discount rate, however. Businesses who are looking at how to invest their money take into account something called the weighted average cost of capital. We will explore this issue in a future article.

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## What is Discounted Cash Flow (DCF)?

Discounted cash flow (DCF) is a financial model that is used to determine what an investment is currently worth by projecting its future cash flows.

DCF is useful for people who invest in companies or securities, whether they are buying a company or stock in a corporation.

Business owners also find this valuation method useful for making decisions about budgeting for new projects or investments.

## Key Highlights of DCF

• DCF can help investors to determine if an investment is worthwhile by forecasting the projected future cash flows.
• The discount rate is used to calculate DCF or, in other words, the current value of projected cash flows.
• If an investment DCF is greater than its current cost, it may be a good opportunity.
• For most businesses, the discount rate is the weighted average cost of capital (WACC.) This is due to how it takes the rate of return that shareholders can expect into account.
• DCF does have some limitations, such as inaccuracy resulting from the predicted cash flows.

## Discounted Cash Flow (DCF) Formula

(Cash flow for the first year / (1+r)1)+(Cash flow for the second year / (1+r)2)+(Cash flow for N year / (1+r)N)+(Cash flow for final year / (1+r)

r = discount rate

N = period of time

## How to Use Discounted Cash Flow

A DCF is used to estimate how much money an investor will receive from a proposed investment when the investment is adjusted to account for the time value of money.

The time value of money is the idea that money today provides more benefits than an equal amount of money in the future due to the ability to earn interest on the money.

This makes DCF a useful tool in any case in which someone pays out money but expects to get additional money in turn later.

Suppose the annual interest rate is 3%, and someone puts \$10.00 dollars in savings.

In one year, they will have \$10.30.

If payment is not received for one year, it will have a present value of \$9.62 because you will be unable to invest it.

Generally, companies will use their weighted average cost of capital (WACC) as the discount rate when calculating the discounted cash flow.

By using (WACC), companies can account on the amount their shareholders would expect to make in return for financing its assets.

### Example

Suppose a business is considering an investment and their WACC is 4%, so the discount rate will be 4%.

The business’s initial investment will be nine million, and the investment will continue for a period of six years.

When added up, the discounted cash flows are \$12,635,264.

When the \$15 million initial investment is subtracted, the net present value is \$2,364,736.

This project is a good choice since there is a profit even after the future cash flows are discounted.

## The Limitations of DCF

When calculating cash flows in the future, it’s essential not to estimate them too high, or you could find yourself picking a project that will not make money.

However, if you estimate cash flows that are too low, it could cause the investment to look more costly than it really is, potentially causing you to pass up a good investment.

Discount rates are an estimate, but they must be calculated carefully to ensure this financial model is useful.

## How is DCF Calculated?

In order to calculate DCF, you will perform a series of steps. The first is to forecast the investment’s expected future returns.

Next, you will determine an interest rate (discount rate), and this is normally calculated by taking into account the potential cost of alternative investments you could make with the same level of risk.

Lastly, you will apply your discount rate to the investment’s predicted cash flows.

This can be done manually or through a computer application or financial calculator.

## DCF Calculation Example

Suppose the discount rate is 7% and the opportunity for an investment that would return \$250 for the next four years.

You want to know what the value of this investment is today or, in fewer words, its present value for this future income stream.

Since money earned in the future is not as valuable as money now, you will use your 7% discount rate to reduce the future returns of this investment to their present value.

## What Is the Difference Between DCF and Net Present Value (NPV)?

DCF and NPV are very similar in concept.

However, to find the NPV, another calculation is added to the discounted cash flows.

After the predicted cash flows are calculated, the discount rate is selected, and the cash flows are discounted, NPV requires that the initial investment in the project be deducted from the DCF of the investment.

FundsNet requires Contributors, Writers and Authors to use Primary Sources to source and cite their work. These Sources include White Papers, Government Information & Data, Original Reporting and Interviews from Industry Experts. Reputable Publishers are also sourced and cited where appropriate. Learn more about the standards we follow in producing Accurate, Unbiased and Researched Content in our editorial policy.

Harvard Business School ” Company Valuation Using Discounted Cash Flow ” Page 1 . November 16, 2021

Wichita Center for Management Development ” Discounted Cash Flow: Application and Misapplication ” White paper. November 16, 2021

## Comparing two methods

Under the income approach, future cash flow drives value. Although that sounds simple, there are several methods that fall under the income approach, including discounted cash flow and capitalization of earnings. How do these two commonly used methods compare and which one is appropriate for a specific investment? Here are some answers to help clarify matters.

## Discounting basics

The International Glossary of Business Valuation Terms defines discounted cash flow as “a method within the income approach whereby the present value of future expected net cash flows is calculated using a discount rate.” In other words, this method entails these basic steps:

Compute future cash flows. In terms of cash flow, potential investors are generally trying to determine what’s in it for them and an acceptable return on investment. Often the starting point for estimating expected cash flow over a discrete discounting period of, say, five or seven years, is based on historical earnings. Then, the valuation expert calculates a terminal (or residual) value, which, in theory, represents how much the business could be sold for after the discrete discount period. (In reality, the business probably won’t be sold at that time, however.)

Discount future cash flows to present value. The valuation expert adjusts the cash flow forecast to present value using a discount rate based on the risk of the investment. If equity cash flows are computed in the first step, they’re discounted using the cost of equity. Conversely, if cash flows to both equity and debt investors are computed, they’re discounted using the weighted average cost of capital.

The value of the business is represented by the sum of those present values represents. The valuation professional may also need to subtract interest-bearing debt to arrive at the value of equity, depending on the nature of the expected cash flows that are discounted.

## Fundamentals of capitalization

The same valuation glossary defines capitalization of earnings as “a method within the income approach whereby economic benefits for a representative single period are converted to value through division by a capitalization rate.” Although this sounds similar to the discounted cash flow method, it’s actually simpler. (Note: The term “earnings” typically refers to cash flow when valuation experts use this method, because capitalization rates are based on discount rates used in the discounted cash flow method.)

This method assumes that future cash flow will grow at a slow, steady pace into perpetuity, instead of calculating cash flows over a discrete discount period based on varying growth and performance assumptions. The method is based on the assumption that a single period (with modest adjustments for growth) provides a reliable estimate of what the business will generate for investors in the future.

As such, this method requires two simplified steps:

1. Compute expected cash flow for a single period.
2. Divide cash flow from the single period by a capitalization rate.

A critical component of this method is the long-term sustainable growth rate. Under the Gordon Growth Model — which is often used to value perpetuities — cash flow from a single period is multiplied by one plus the long-term growth rate. Then, the long-term growth rate is subtracted from the discount rate to arrive at a capitalization rate. Again, depending on the nature of the expected cash flow, the valuation professional may also need to subtract interest-bearing debt to arrive at the value of equity.

## How to decide which method to use

Which method is more appropriate for a particular investment? In general, the discounted cash flow method provides greater flexibility if management expects short-term fluctuations in growth, revenue and expenses, leverage, working capital needs and capital expenditures. It’s particularly useful for high-growth businesses and start-ups that aren’t yet profitable — or when calculating damages over a finite period.

On the other hand, the capitalization of earnings method is often applied by established businesses with stable earnings because they generally find it easier and equally reliable. This method is also convenient when valuing a business for litigation purposes because it’s easier to explain to a judge or jury than a sophisticated discounted cash flow model. However, the discounted cash flow method is widely accepted in more sophisticated courts, such as the U.S. Tax Court or federal courts.

## Expertise is essential

It’s critical to contact a credentialed valuation professional for more information on how these methods work. They can help you decide whether these methods are right for a particular investment.

This is Part 1 of the summary of the concept and technique of the Discounted Cash Flow model from the book Warren Buffett’s Three Favorite Books and the course on Buffetts Book.com by Preston Pysh.

## Summary

• Warren Buffet introduced Owner’s Earnings to refer to the part of reported earnings that actually benefit shareholders.
• Free Cash Flow is a good approximation of the Owner’s Earnings. It can be found on the Cash Flow Statement of a company.

## Owner’s Earnings

Free cash flow is important because it’s relevant to the concept of Owner’s Earnings introduced by Warren Buffet.

At a time when Wall Street was using the net income of a company as an indicator to buy or sell its stock, Buffet introduced Owner’s Earnings. The idea is that we as owners (i.e. shareholders) should value a company by the earnings that it will generate for us. And only part of that net income is actually going into our pocket.

To understand this, let’s see what happens to the earning after it is produced —

1. A part of it can be paid to shareholders as dividends.
2. The rest of it will go back to the business. It might be spent on maintenance tasks so that the business can keep operating at its current level (e.g. repairing equipment). It can also be spent on expanding assets (e.g. purchasing investments).

Buffet thinks that owners of a business only benefit from the earnings that are paid as dividends or are used to expand assets.

When earnings are paid as dividends, they benefit the owners directly. When earnings are used to expand assets, they increase the asset value of the business, thereby increasing its market price and benefitting the owners. They are the Owner’s Earnings.

## Free Cash Flow

At the time when Buffet introduced Owner’s Earnings, companies were not required to publish their Cash Flow Statements. Today we can find the Cash Flow Statements on most of the financial sites . And the Free cash flow on the statement is a good approximation to Owner’s Earnings.

As you can see from the red rectangle, Free Cash Flow = Operating Cash Flow – Capital Expenditure. Operating Cash Flow approximates the earnings in the diagram above. And Capital Expenditure approximates the maintenance expenditure.

You might notice that we are using Operating Cash Flow instead of Net Income that is also available on the report. This is because Net Income includes non-cash components (e.g. depreciation as an expense) that are irrelevant to our calculation. Operating Cash Flow is a more accurate representation of the cash available to the business and its shareholders.

There are some discussions around using capital expenditure to estimate maintenance expenditure . Some argued that capital expenditure can be used to expand assets in addition to maintaining current performance. However, many regard it as a conservative and simple approximate. In fact, Free Cash Flow and Owner’s Earnings are used interchangeably in the course.

Now that we understand what the Owner’s Earnings and Free Cash Flow are. Let’s introduce the Discounted Cash Flow model for estimating the intrinsic value of a stock.

The general idea is to use free cash flow to estimate the total earnings you will receive during your ownership, and then discount it back to today’s value.

There are 6 steps:

1. Estimate the free cash flow

2. Determine the short term

3. Estimate the short term growth rate

4. Determine the discount rate

5. Determine the growth into perpetuity

6. Find the number of shares outstanding

7. Calculate the Intrinsic Value —

Intrinsic Value = (Sum of short term cash flow + Sum of perpetuity cash flow)/(Number of shares outstanding)

In Part 2, I will go through each step using a real stock.

Feel free to leave a comment below to let me know if this article helps you. Have a wonderful day!

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##### Tally Solutions | Published Date: | –> Updated on: December 13, 2021
• Introduction to Cash Discount
• What is Cash Discount?
• Terms of Cash Discounts
• Cash Discount – Advantages and Disadvantages
• Cash Discount Methods and Examples

## Introduction to Cash Discount

What comes to mind when we hear the word ‘DISCOUNTS’? It’s all about the reduction in selling price. While this looks obvious, a business does offer a kind of discount which is not at the time of selling but at a later stage.

This sounds little different, isn’t it? Why? We all have personally experienced a discount which is an upfront reduction in selling price. While the business does offer such type of discount (upfront reduction in selling price), there is another type which is popularly known as ‘Cash Discount’.

Generally, business practises 2 types of discount as shown in the below image.

In this article, we will understand the Cash discount and how to calculate it.

## What is Cash Discount?

Every trader is pleased when they see that their customers have paid the invoices made out to them. And to grant an incentive for this, many service providers and distributors offer a price reduction in the amount of a certain percentage of the invoice total. This price reduction is called a cash discount.

In simple words, a cash discount can be termed as an incentive that a seller offers to a buyer in return for paying a bill owed before the scheduled due date.

## Terms of Cash Discounts

Cash discounts also called as ‘early payment discount’ or ‘prompt payment discount’. Although we have defined cash discount above, understanding the concept still involves understanding the related terms. Here are three terms you should know:

Period of discount –

The time a customer is given to pay the invoice and receive the discount before the deadline.

The percentage amount that can be deducted from the total invoice amount.

Amount of cash discount –

The price reduction that results once the discount percentage has been applied.

The cash discount is generally written in the following manner:

### 5/30, N/45

This is not a location coordinates. This is the way cash discount terms are written. Let’s understand this:

## Cash Discount – Advantages and Disadvantages

### Advantages of cash discount

• Encourage debtors to pay on time
• Reduces the chances for the occurrence of bad debts
• Helps in running of trade cycle as cash will be available earlier due to reduced length of time
• Cash discounts may increase sales as new customers will be entertained with the cash discount part that the firm offers.

### Disadvantages of cash discount

• Results in reduced cash inflows from debtors as cash discounts are offered.
• Net profits are affected as discount expenses are charged to profits.

## Cash Discount Methods and Examples

### Ordinary dating method

A credit term of [ 2/10, n/30] means that you will get a discount of 2% if you clear your account within 10 days. In other words, if you make the payment within 10 days from the date of the invoice, you will be eligible for a 2% discount. It also means that you must pay the bill within 30 days to avoid interest charges.

Let’s understand this with an example

Mr Rahul received an invoice for Rs. 3,000 /- dated 22 November 2019 with terms [ 2/10, n/30]. He paid the whole amount on 30 November 2019. How much did Mr Rahul effectively paid for the bill?

• Date of Invoice: 22 nd November 2019
• Day 1 of the cash discount period. : 23 rd November 2019
• Last day of the Cash discount period: 31 st November 2019
• Date of payment: 30 th November 2019

Cash discount. = Price x Discount rate

Amount effectively paid by Mr Rahul. = Bill value (- ) Cash discount

= Rs. 3,000 (- ) Rs. 60

#### End of the month method [ E.O.M ]

A credit term of [ 2/10,n/30 E.O.M ] means that you will get a discount of 2% if you pay your account within the first 10 days of next month. In other words, if you make the payment within the first 10 days of next month from the date of the invoice, you will be eligible for a cash discount. It also means that you must pay the bill within the first 30 days of next month to avoid interest charges.

Let’s understand this with an example

Mr Amit received an invoice for Rs. 3,000 /- dated 05 th November 2019 with terms [ 2/10, E.O.M ]. He paid the whole amount on 10 th December 2019. How much did Mr Amit effectively paid for the bill?

• Date of Invoice: 05 th November 2019
• Day 1 of the cash discount period: 01 st December 2019
• Last day of the Cash discount period: 10 th December 2019
• Date of payment. : 10 th December 2019

Cash discount = Price x Discount rate

= Rs.3,000 x 2 / 100

Amount effectively paid by Mr Amit = Bill value (-) Cash discount

#### Receipt of goods dating method [ R.O.M ]

A credit term of [ 2/10 R.O.M] means that you will get a discount of 2% if you make the payment within the first 10 days after the goods are received.

Let’s understand this with an example

Mr Jagdish received an invoice for Rs. 3,000 /- dated 10 th November 2019 with terms [ 2/10, n/30 R.O.G] for a shipment that arrived on 5 th of December 2019. Mr Jagdish paid for the bill in full on the 10 th of December 2019. How much did Mr Jagdish effectively paid for the bill?

• Date of Invoice: 10 th November 2019
• Day 1 of the cash discount period: 06 th December 2019
• Last day of the Cash discount period: 14 th December 2019
• Date of payment: 10 th December 2019

Cash discount = Price x Discount rate

= Rs. 3,000 x 2 / 100

Amount effectively paid by Mr Jagdish = Bill value ( – ) Cash discount

= Rs. 3,000 ( – ) Rs. 60

Now we have understood the cash discount and methods to calculate it, the next big question as a business owner you must answer is should you avail the cash discount? it’s obvious that opting discount looks beneficial as you are going to pay lesser but owing to certain factors, it is not beneficial always.

To answer this question, you need to calculate the cost of not taking the discount. Basically, you need to check the opportunity cost or implied cost of not availing the discount vis-a-vis the return on investment or cost of credit. Find out why it is not beneficial and how to calculate the opportunity cost by reading our article ‘Cost of Accounts Payable’

Accounting CPE Courses & Books

## What is the Discounted Cash Flow Method?

The discounted cash flow method is designed to establish the present value of a series of future cash flows. Present value information is useful for investors, under the concept that the value of an asset right now is worth more than the value of that same asset that is only available at a later date. An investor will use the discounted cash flow method to derive the present value of several competing investments, and usually picks the one that has the highest present value. The investor may not pick an investment with the highest present value if it is also considered a riskier opportunity than the other prospective investments.

## The Calculation of Discounted Cash Flow

The steps to be taken to calculate present value under the discounted cash flow method are as follows:

Itemize all positive and negative cash flows associated with an investment. This can include the following:

The initial purchase

Subsequent maintenance on the initial purchase

The working capital investment associated with the initial purchase

The profit on sales of the goods and services derived from the investment

The amount of income tax sheltered by the depreciation on the acquired asset

The working capital reduction that occurs once the asset is later sold

The salvage value of the asset that is expected when it is sold at the end of its useful life

Determine the cost of capital of the investor. This is the after-tax cost of the investor’s debt, preferred stock, and common stock. It may also be adjusted upward to account for the additional risk associated with an investment. The cost of the investor’s common stock is the most expensive and the most difficult to calculate.

Plug the cash flows from Step 1 and the cost of capital from Step 2 into the following calculation to derive the present value of all cash flows:

Net present value = X × [(1+r)^n – 1]/[r × (1+r)^n]

X = The amount received per period
n = The number of periods
r = The required return (cost of capital)

The preceding formula can be plugged into the Excel electronic spreadsheet to arrive at the discounted cash flow figure.

## Advantages of the Discounted Cash Flow Method

Ultimately, one of the best ways to determine the value of an asset is to derive the discounted cash flows associated with it. This is a highly quantitative approach to determining value, as opposed to a variety of qualitative methods that tend to overvalue assets. At a minimum, an asset analysis should always include a review of discounted cash flows, even if other valuation methods are being used as well.

## Disadvantages of the Discounted Cash Flow Method

There are several concerns with using the discounted cash flow method, not least of which is the difficulty of deriving accurate estimates for it. The person conducting the analysis might estimate cash inflows and outflows too high or too low, or may not use a valid discount rate. The result can be inordinately positive or negative outcomes that make the analysis useless for decision-making purposes.

## What is a discounted cash flow model?

A discounted cash flow model (DCF model) is a model to look at discounted cash flows of a firm.

## How does it work?

1. Project out financial statements, including Free Cash Flow
• Typically, we forecast out 5 years then assume a Terminal Value
2. Discount Free Cash Flow and the terminal value using an appropriate discount rate

## Walk Me Through a DCF (Interview Question)

This is a very common interview question that comes up in corporate finance interviews.

1. Project out financial statements, typically for 5 years
2. Calculate terminal value using Gordon Growth Model or an exit multiple
3. Discount back to time 0 using an appropriate discount rate, such as WACC for FCFF

## DCF Assumptions and Frequently Asked Questions

### Discount Rate to Use

The discount rate used depends on what type of Free Cash Flow we’re discounting. If we’re discounting Free Cash Flow to Firm (FCFF), then we use the Weighted Average Cost of Capital. If we’re discounting Free Cash Flow to Equity (FCFE), then we use the cost of equity as the discount rate.

### How many years do we project out?

The key here is to project for as many years as we can have reliable projections UNTIL the cash flows stabilize. Typically 5 years is used because for most firms it’s hard to project accurately beyond 5 years. For reference, keep in mind that most equity analysts, whose main job is to forecast the company’s performance, doesn’t get the next quarter perfectly accurate.

If the cash flows going into the future will continue to be the same, you don’t need to forecast out every year because the information is repetitive. For example, for a royalty property that will generate \$1 million a year in perpetuity in free cash flow, you don’t need to project out anything. You just take the present value of the perpetuity and it’s done because every year’s free cash flow is the exact same.

### Enterprise Value or Equity Value?

If we’re discounting Free Cash Flow to Firm (FCFF) with the weighted average cost of capital, then we end up with Enterprise Value. If we’re discounting Free Cash Flow to Equity (FCFE) with the cost of equity, then we end up with Equity Value.

Enterprise Value = Equity Value + Net Debt + Minority Interest Equity Value = Enterprise Value – Net Debt – Minority Interest (simple algebra)

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Posted on October 18, 2012 by systematicinvestor in R bloggers | 0 Comments

Today I want to show a simple example of how we can value a company using Discounted Cash Flow (DCF) analysis. The idea is to compute the company’s Intrinsic Value based on the discounted future cash-flows. To compute future cash-flows I will use the historical Free Cash Flow growth rate. To compute present value of these cash flows I will use a conservative 9% discount rate. If you want to read more about the Discounted Cash Flow (DCF) analysis, I recommend following references:

First let’s load historical prices and fundamental data for Apple (AAPL) using the Systematic Investor Toolbox.

Next let’s extract fundamental data for Discounted Cash Flow (DCF) analysis

Next I created a simple function to estimate company’s Intrinsic Value using Discounted Cash Flow (DCF) analysis.

Finally, let’s compute AAPL’s Intrinsic Value and create plots

The Intrinsic Value calculations are highly sensitive to your assumptions about the company’s Growth Rate and Discount Rate used in the Discounted Cash Flow (DCF) analysis.

AAPL has experienced the amazing Growth Rate over the last 5 years and the big question is whether AAPL will be able to maintain this Growth Rate in the future. If yes, then the stock price can easily reach new highs as suggested by the Discounted Cash Flow (DCF) analysis.

Used by investors to determine whether to invest in a business or project, discounted cash flow (DCF) is a handy tool for determining the fair value of an investment. It can work for projects, real estate, bonds, publicly traded stocks, and businesses, as well as virtually any type of investment that is expected to produce a cash flow. Check out our comprehensive guide to learn more about the advantages of discounted cash flow and how to do a DCF analysis.

## Discounted cash flow models explained

Discounted cash flow is a valuation method that is used to work out the value of an investment (asset, company etc.) based on its future cash flows. To do this, it makes use of the time value of money (TMV) – the assumption that £1 today will be worth more than £1 tomorrow. In essence, DCF models are used to determine a company’s value today based on projections of how profitable it will be in the future.

## What is the discounted cash flow formula?

Wondering how to do a DCF analysis? Although it’s a simple concept, DCF models can be quite difficult to get to grips with. Essentially, you need to project the cash flows you expect an investment to produce going forward, before discounting each future cash flow to present value. After the present value has been found, investors will evaluate the profitability of the investment in question. Generally speaking, the DCF valuation must be higher than the cost of the investment to justify investing in it.

The basic discounted cash flow formula is as follows:

These terms might be a little unfamiliar, so here’s a quick guide explaining what they mean:

CFt – Cash flow in period t

r – Discount rate based on the riskiness of cash flows

t – the life of the asset that’s being valued

## What are the advantages of discounted cash flow?

Discounted cash flow is probably one of the best metrics for estimating the intrinsic value of an investment. It demands consideration of many different factors, including profit margins and future sales growth, while it also requires analysts to take into account the time value of money. This all serves to provide a more accurate valuation of a project or business, giving investors a better foundation from which to make a decision about the value of an investment.

## What are the limitations of DCF valuation?

While DCF models are incredibly useful, there are some drawbacks that should be considered. Most importantly, the success of DCF analysis relies on your ability – at least to a certain extent – to predict the future. If your estimate of future cash flows isn’t accurate, then your DCF models won’t be worth very much. Businesses often encounter unforeseen hurdles, while it’s also possible that a product or service could be introduced and become wildly more popular than expected. Put simply, if a project is very complex or there are too many variables, the DCF analysis is unlikely to be accurate.

## What’s the verdict?

Overall, discounted cash flow can be an excellent way to determine whether an investment is worthwhile. So, if you’re considering buying a business, a piece of equipment, or any other asset that provides a cash flow, it can be a useful tool to keep in your arsenal.

## We can help

GoCardless helps you automate payment collection, cutting down on the amount of admin your team needs to deal with when chasing invoices. Find out how GoCardless can help you with ad hoc payments or recurring payments .

GoCardless is used by over 70,000 businesses around the world. Learn more about how you can improve payment processing at your business today.

Used by investors to determine whether to invest in a business or project, discounted cash flow (DCF) is a handy tool for determining the fair value of an investment. It can work for projects, real estate, bonds, publicly traded stocks, and businesses, as well as virtually any type of investment that is expected to produce a cash flow. Check out our comprehensive guide to learn more about the advantages of discounted cash flow and how to do a DCF analysis.

## Discounted cash flow models explained

Discounted cash flow is a valuation method that is used to work out the value of an investment (asset, company etc.) based on its future cash flows. To do this, it makes use of the time value of money (TMV) – the assumption that \$1 today will be worth more than \$1 tomorrow. In essence, DCF models are used to determine a company’s value today based on projections of how profitable it will be in the future.

## What is the discounted cash flow formula?

Wondering how to do a DCF analysis? Although it’s a simple concept, DCF models can be quite difficult to get to grips with. Essentially, you need to project the cash flows you expect an investment to produce going forward, before discounting each future cash flow to present value. After the present value has been found, investors will evaluate the profitability of the investment in question. Generally speaking, the DCF valuation must be higher than the cost of the investment to justify investing in it.

The basic discounted cash flow formula is as follows:

These terms might be a little unfamiliar, so here’s a quick guide explaining what they mean:

CFt – Cash flow in period t

r – Discount rate based on the riskiness of cash flows

t – the life of the asset that’s being valued

## What are the advantages of discounted cash flow?

Discounted cash flow is probably one of the best metrics for estimating the intrinsic value of an investment. It demands consideration of many different factors, including profit margins and future sales growth, while it also requires analysts to take into account the time value of money. This all serves to provide a more accurate valuation of a project or business, giving investors a better foundation from which to make a decision about the value of an investment.

## What are the limitations of DCF valuation?

While DCF models are incredibly useful, there are some drawbacks that should be considered. Most importantly, the success of DCF analysis relies on your ability – at least to a certain extent – to predict the future. If your estimate of future cash flows isn’t accurate, then your DCF models won’t be worth very much. Businesses often encounter unforeseen hurdles, while it’s also possible that a product or service could be introduced and become wildly more popular than expected. Put simply, if a project is very complex or there are too many variables, the DCF analysis is unlikely to be accurate.

## What’s the verdict?

Overall, discounted cash flow can be an excellent way to determine whether an investment is worthwhile. So, if you’re considering buying a business, a piece of equipment, or any other asset that provides a cash flow, it can be a useful tool to keep in your arsenal.

## We can help

GoCardless helps you automate payment collection, cutting down on the amount of admin your team needs to deal with when chasing invoices. Find out how GoCardless can help you with ad hoc payments or recurring payments .

GoCardless is used by over 60,000 businesses around the world. Learn more about how you can improve payment processing at your business today.

Gordon Growth Model is a part of Dividend Discount Model. This model assumes that both the dividend amount and the stock’s fair value will grow at a constant rate. To put in simple words, this model assumes that the dividend paid by the company will grow at a constant percentage.

Gordon growth model, also known as ‘Constant Growth Rate DCF Model, has been named after Professor Myron J. Gordon. As the name implies, this model works on the underlying assumption that the company will continue to pay the dividend amount as a fixed multiple of growth in the future, as it is paying now. It is an appropriate model to value companies who increase the dividend by fixed rate every year. Let us now look at how to calculate the value of the stock using constant growth model:

## Formula for Gordon Growth Model / Constant Growth Rate DCF Method

Stock Value (p) = D1/ (k-g)

Where, p = Intrinsic value of the stock/equity

k = Investors required rate of return, discount rate

g = Expected growth rate (Note: It should be assumed to be constant)

D1= Next years expected annual dividend per share

When k and g, i.e. investors required rate of return and expected growth rate do not change over the years, so the stocks fair/intrinsic value will increase annually by the rate of dividend increase. To put it in simple words, both the dividend amount and the stock price/value will increase at a constant growth rate.

Let us look at the example below for a better understanding of the concept of constant growth model.

## Example for Calculating Value of Stock Using Gordon’s Growth Model

Let us say a stock pays a dividend of \$ 5 this year. The dividend has been growing at the rate of 10% annually. Assuming a 15% required rate of return; the value of the stock can be calculated as follows:

In the given example;

Current year Dividend D0 = \$ 5

 Year Expected Annual Dividend Discount Rate Expected Growth Rate Stock Value 1 \$5*(1+0.10) = \$5.5 15% 10% \$ 5.5/(0.15-0.10) = \$ 110 2 \$5.5(1+0.10) = \$6.05 15% 10% \$ 6.05/(0.15-0.10) = \$ 121 3 \$6.05(1+.10) = \$6.655 15% 10% \$ 6.655/(0.15-0.10) = \$ 133.1 4 \$6.655(1+.10) = \$7.3205 15% 10% \$ 7.3205/(0.15-0.10) = \$ 146.41

Year 1 Dividend will be = \$ 5 x (1+10%) ^1 = \$ 5.50

Year 2 Dividend will be = \$ 5.50 x (1+10%) ^1 = \$ 6.05

Year 3 Dividend will be = \$ 6.05 x (1+10%) ^1 = \$ 6.655

Year 4 Dividend will be = \$ 6.655 x (1+10%) ^1 = \$ 7.3205

To sum up the calculations, 110*1.1 = 121, 121*1.1 = 133.1 & 133.1*1.1=146.41 respectively for each year. Hence the stock value grows by a constant rate of 1.1 over the next 4 years and will continue to grow by 10% for all the forth coming years. According to the constant growth model, if the stock’s value is \$110 for the next year, but if the stock is trading at \$100 then it is undervalued.

## Variations in the Price of the Stock Calculated Under Gordon’s Constant Growth Rate DCF Model

• Assuming the company does well in the next year and grows at a growth rate of more than 10% let us say 12%, the price of the stock will be:

p = \$ 5.5/ (0.15-.012) = \$ 183.33

• Conversely, if the company does not do very well and the growth rate goes down, let us assume it goes down to 8%. The price of the stock will be:

p = \$ 5.5/ (0.15-0.08) = \$ 78.57

The model is applied and used for its simplicity and suitability for companies with stable growth and established dividend payout ratios. The model, however, comes with a set of limitations; which one needs to know so as to enable a better understanding of the model.

## Disadvantages of Gordon Growth Model

• The constant growth model of equity valuation under discounted cash flow model comes with an assumption that the dividends paid by the company will grow at a constant rate. This is not a true assumption for declining or growing companies.
• Also, constant growth means the company would continue to grow at constant rate till eternity, which does not align with real world scenario and the said approach can lead to estimation errors.
• The growth rate in an industry is the key input. Mathematically this model may generate output value as infinity if the cost of growth approaches very close to the cost of equity and the value may go negative if growth rate goes above the cost of equity.

Conclusion

Equity valuation model helps the investors to make calculative investment decisions. If the fair or intrinsic value of the stock calculated using these models is higher than the price of stock at which it is being traded; then it is advisable to buy the stock as it is undervalued and the price is expected to go up in future.

Similarly, if the fair or intrinsic value of the stock is lower than the traded price of the stock, then the stock is overvalued and the price is expected to go down in future and one may look to sell the stock.

## Sanjay Bulaki Borad

Sanjay Borad is the founder & CEO of eFinanceManagement. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain “Financial Management Concepts in Layman’s Terms”.

The Discounted Cash Flow Method is a method to value a project by taking all future projected cash flows of the project and discounting them back to time zero (date of purchase) using a predetermined discount rate (the discount rate when used in a DCF to look at an investment can be looked at as synonymous to an investor’s targeted IRR). The value that is deduced from doing this is what an owner/investor would be willing to pay today in order to receive the projected cash flows from the project in the future and take on the risk.

#### Example

An investor is looking at an office building to purchase and hold for five years. The investor will use all his own cash to buy the project and after underwriting he believes the project will produce the following cash flows:

This investor knows he can put this same money in a slightly less risky investment at 7% and so in order to consider this opportunity over the other, he values the incremental risk at a 1% premium and thus, requires that the cash flow above results in an 8% return. In other words, he is looking to achieve an 8% IRR on this cash flow. The investor now needs to resolve what he would pay today in order to earn 8% on the money invested.

##### Solving Formulaically

To solve this formulaically for annual periods, we need to apply this formula to the cash flow above:

Inputting our assumptions gives us the following:

Simply adding this all up provides us with a purchase price of \$4,723,211. So, if our investor were to consider this deal, he would need to be able to close on this property at \$4,723,211 or less.

##### Solving with Excel

Implementing a Discounted Cash Flow Analysis using Excel is actually quite simple with the =NPV() formula. Click the mouse into a blank cell and type

Once you do that, the formula guide will ask for a rate. Type

after you type the comma, take the mouse and highlight all the cells that have the cash flows in it and press Enter. This should return the present value of the cash flows discounted at the required rate. If this is not fully clear to you, please watch the video below for further explanation of the DCF Method.

#### DCF Method Video

About the Author: Michael has spent a decade managing, consulting, and working in various capacities on more than \$7BN worth of real estate opportunities. Most recently, he worked at Hines managing large-scale development projects in San Francisco. Michael is currently the Chief Operating Officer and member of the founding team at Stablewood Properties. Michael has both an MBA and Master in Real Estate with a concentration in Real Estate Finance from Cornell University.

Seasoned investors often use valuation metrics to thoroughly assess a company’s performance, its financial health and gauge its future prospects. Both shareholders and creditors show keen interest in these metrics. So, why is there a need for valuation metrics? The answer is that valuation of a stock or a company helps investors and creditors to know whether the same is being undervalued or overvalued by the market.

There are several methods of valuing a company or an asset, discounted cash flow (DCF) being one of them. Here, we will try to understand the concept of DCF and learn about some of its advantages and flaws.

## What is discounted cash flow?

Discount Cash Flow analysis or DCF analysis is a valuation method used to assess the present value of a company or an asset. The valuation is based on the number of cash flows that the company or asset can generate in the future. Essentially, this method estimates the company’s or asset’s future cash flow projections.

The key here is to understand the ‘time value of money’ concept. It says that money in the future is not worth the same as money today. To estimate the future value of money, you must discount it. In simple terms, this method accounts for the fact that an investor loses the chance to invest the same money in other alternatives and earn more from it.

## Important points about DCF

Here are certain important aspects to note about DCF:

• While calculating DCF, the underlying assumption is that a company or an asset will make money or generate cash flows in the future.
• Second assumption of this method is that the value of money today is worth more than what it will be in the future.
• The term ‘discounted’ in this method refers to adjusting for the diminishing value of money.
• Cash flow refers to the money generated by a business or an asset

## How to calculate DCF

Here is the formula for DCF calculation:

Discounted Cash Flow = CF1 / (1+dr) 1 + CF2/ (1+dr) 2 +….. + CFn/ (1+dr) n

Let’s understand the components in simpler terms:

• Discounted Cash Flow–Sum of all future discounted cash flows expected to be generated by an asset or a company.
• CF – Total cash flow for a particular year. CF1 is the first year, CF2 is the second year, and so on.
• dr – Discount rate that is the target rate of return expected from the investment. It is the weighted average cost of capital (WACC).

## How is DCF used?

When investors contemplate an investment in either a stock or a company, etc, they need to project and discount the expected cash flows for appropriate investment decisions. In case an investment is priced below the sum of discounted cash flows, it indicates that the investment is undervalued and can be a potentially rewarding investment. In case the price is higher than the sum of discounted cash flows, the asset is most likely overvalued.

The DCF calculation is ideal for certain industries or companies since it evaluates a company’s current value by projecting its future cash flows or profits. This necessitates estimation and assumption about the future business growth and profitability, among other aspects.

In simple terms, this valuation method is ideal for larger companies that have a relatively stable growth profile. It may not work for projecting growth of smaller-sized companies or those that experience volatility. Thus, the sectors such as utilities, oil and gas, etc see higher usage of DCF since the income, expenditure and growth are relatively stable over time.

## What are the advantages of DCF?

For estimating the intrinsic value of a stock or a company, a DCF model uses a lot of detail. Here are some of its primary advantages:

• Easy to use, very detailed and takes into account important assumptions with regards to the business
• It helps in estimating the “intrinsic” value of a business or asset
• The calculation does not require any comparable asset or companies
• It can also be used for analyzing mergers and acquisitions
• Used to calculate the internal rate of return IRR of an investment for critical investment decisions
• The model allows multiple scenarios to be considered for sensitivity analysis

## What are the disadvantages of DCF?

Some of the fundamental drawbacks of this model are:

• It requires significant time for projecting the variables involved.
• Although certain parameters like operating cost and revenue are easier to anticipate in advance, aspects like capital expenditure, funding mix, and other investments may not be easy to estimate. Therefore, a minor deviation in some of the parameters can result in a major shift in the company or stock’s valuation.
• DCF is typically used to project for a longer duration. However, long-term projections may not always be accurate considering the possible volatility and cyclicality in any business or asset.

## Conclusion

While the model is prone to errors and overcomplexity, investors and analysts use it often to gauge the intrinsic value of an investment. It allows informed decision making by arriving at a somewhat accurate present value.

By Sean R. Saari, Partner, Advisory Services

Investors in publicly-traded companies have the luxury of knowing the value of their investment at virtually any time. An internet connection and a few clicks of a mouse are all its takes to get an up-to-date stock quote. Of all U.S. companies, however, less than 1% are publicly-traded, meaning that the vast majority of companies are privately-held. Investors in privately-held companies do not have such a readily available value for their ownership interests. How are values of privately-held businesses determined, then? Each month, this eight blog series will answer that question by examining a key component of how ownership interests in privately-held companies are valued.

Income Approach

There are two income-based approaches that are primarily used when valuing a business, the Capitalization of Cash Flow Method and the Discounted Cash Flow Method. These methods are used to value a company based on the amount of income the company is expected to generate in the future.

The Capitalization of Cash Flow Method is most often used when a company is expected to have a relatively stable level of margins and growth in the future – it effectively takes a single benefit stream and assumes that it grows at a steady rate into perpetuity. The Discounted Cash Flow method, on the other hand, is more flexible than the Capitalization of Cash Flow Method and allows for variation in margins, growth rates, debt repayments and other items in future years that may not remain static. As a result, the Capitalization of Cash Flow Method is typically applied more often when valuing mature companies with modest future growth expectations. The Discounted Cash Flow Method is used when future growth rates or margins are expected to vary or when modeling the impact of debt repayments in future years (although it can still be used in same sort of “steady growth” situations in which the Capitalization of Cash Flow Method can be applied).

More information related to the Discounted Cash Flow Method is provided below along with an example:

Discounted Cash Flow Method The Discounted Cash Flow Method is an income-based approach to valuation that is based upon the theory that the value of a business is equal to the present value of its projected future benefits (including the present value of its terminal value). The terminal value does not assume the actual termination or liquidation of the business, but rather represents the point in time when the projected cash flows level off or flatten (which is assumed to continue into perpetuity). The amounts for the projected cash flows and the terminal value are discounted to the valuation date using an appropriate discount rate, which encompasses the risks specific to investing in the specific company being valued. Inherent in this method is the incorporation or development of projections of the future operating results of the company being valued.

Distributable cash flow is used as the benefit stream because it represents the earnings available for distribution to investors after considering the reinvestment required for a company’s future growth. The discounted cash flow method can be based on the cash flows to either a company’s equity or invested capital (which is equal to the sum of a company’s debt and equity). A “direct to equity” discounted cash flow method arrives directly at an equity value of a company while a “debt-free” discounted cash flow method arrives at the invested capital value of a company, from which debt must be subtracted to arrive at the company’s equity value. A brief summary of some of the primary differences between a “direct to equity” and a “debt-free” discounted cash flow analysis are presented below:

An example of a “direct to equity” discounted cash flow analysis is presented below:

To summarize, the Discounted Cash Flow Method is an income-based approach to valuation that is based on the company’s ability to generate cash flows in the future.

Discounted cash flow (DCF) is a method used to estimate the value of an investment based on future cash flow. The DCF formula allows you to determine the value of a company today, based on how much money it will likely generate at a future date.

To do this, DCF finds the present value of future cash flows using a discount rate. Once you have the PV it can then be used to evaluate the investment to see whether it is a wise decision.

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Publi&eacute dans la cat&eacutegorie L’évaluation de l’entreprise

Les discounted cash flows (DCF), littéralement « flux de trésorerie actualisés », représentent une méthode d’évaluation des entreprises. Elle consiste à actualiser des flux futurs afin de déterminer la valeur d’une entreprise. Compta-Facile vous propose sa fiche complète sur le discounted cash flows : qu’est-ce que la méthode des DCF ? Comment les calculer ? Quelle est son utilité ?

## Qu’est-ce que la méthode des discounted cash flows ?

La méthode du discounted cash flows consiste à déterminer les revenus que rapporteront une entreprise (on parle de flux de trésorerie futurs) et à les actualiser pour indiquer la valeur d’une entreprise à une date « t » donnée.

Les problèmes soulevés par cette méthode résident principalement dans le choix d’une durée et d’un taux d’actualisation :

• sur la durée : elle dépend de la visibilité de l’entreprise c’est-à-dire de son horizon raisonnable de prévisions. Trop courte, elle accordera une importance considérable à la valeur terminale. Trop longue, elle ramène à une simple extrapolation théorique sans intérêt. Il faudra choisir la durée permettant à l’entreprise d’atteindre son régime de croisière ;
• sur le taux d’actualisation : il est essentiel dans le calcul mais sa méthode de détermination est discutable puisqu’elle n’est généralement réalisable que pour les entreprises côtées en bourse.

## Comment calculer des discounted cash flows ?

### Décomposition de la formule de calcul des discounted cash flows

Pour appliquer la méthode des discounted cash flows, il convient tout d’abord de déterminer les cash flows sur une période donnée (en général entre 4 et 10 ans), puis de les actualiser. Enfin, il est d’usage de rajouter à cette somme la valeur actualisée finale de l’entreprise.

Avec Ft les flux de trésorerie disponibles après impôt

Avec Vt la valeur terminale de l’entreprise à la fin de l’horizon

Avec Icmcc le taux d’actualisation espéré par l’actionnaire (c’est le coût moyen pondéré du capital)

### Calcul des cash flows utilisés dans la méthode des DCF

Il existe différentes formules des cash flows. La principale consiste à partir de l’excédent brut d’exploitation (EBE) et d’y retrancher l’impôt calculé sur le résultat d’exploitation, la variation du besoin en fonds de roulement (BFR) ainsi que le montant consacré aux investissements net des désinvestissements.

### Détermination du taux d’actualisation

Comme nous l’avons indiqué, après avoir déterminé les cash flows sur les périodes concernées, il convient de les actualiser. Le taux d’actualisation retenu correspond généralement au coût moyen pondéré du capital (tenant compte, notamment, du coût de la dette). Il doit refléter le niveau de risque de l’activité de l’entreprise et sa structure financière.

Avec Ccp = coût des fonds propres (rentabilité exigée par les actionnaires)

Et Cd = coût de l’endettement financier

L’utilisation de ce mode de calcul nécessite d’estimer le coût des fonds propres (Ccp) avec la méthode du MEDAF basée sur le bêta des capitaux propres de la société. Or, cette méthode n’est utilisable que pour les sociétés disposant d’un cours en bourse (donc côtées).

Exemple : le passif du bilan d’une entreprise est composé pour 50 % de fonds propres et pour 50 % de dettes financières. La rentabilité exigée par les actionnaires est de 7 % et l’intérêt de l’emprunt de 5 %. Le CMPC est de 5,17 % soit 7 % * 50 % + 5 % * 50 % * ( 1 – 33,1/3% ).

### Calcul de la valeur terminale de l’entreprise

Généralement, la valeur terminale de l’entreprise est calculée avec la formule de Gordon Shapiro. Elle tient compte du montant du dividende, du taux d’actualisation et du taux de croissance constant du dividende.

Avec g = le taux de croissance annuelle du dividende

## Quel est l’intérêt de calculer des discounted cash flows ?

La méthode des discounted cash flows permet d’actualiser (c’est-à-dire de rapporter à une date « t » donnée) la richesse future produite par une entreprise et donc de déterminer sa valeur. Dans cette logique, on considère que l’entreprise vaut ce qu’elle va rapporter (contrairement à la méthode de l’actif net comptable, dans laquelle l’entreprise vaut ce qu’elle possède).

Cette méthode ne doit être utilisée que pour évaluer les entreprises à fort potentiel de croissance, disposant de perspectives de développement intéressantes. En pratique, elle concerne principalement les start-ups, les entreprises souhaitant lever des fonds pour lancer une nouvelle activité et plus généralement toutes les entreprises qui vont vivre des changements au cours des prochaines années.

Pour calculer la valeur de l’entreprise, il convient de retrancher du montant obtenu par les DCF la valeur actualisée de l’endettement net. La logique est la même : il suffit d’actualiser les flux à payer au coût de marché de la dette.