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A discounted cash flow (DCF) model is essential for CFOs looking to make intelligent business decisions for today with insights from the future. It's almost as though people expect us finance professionals to be fortune tellers.
And maybe we are.
The DCF model is a powerful tool that helps us get one step closer to predicting the future. We use them for evaluating a number of financial business decisions.
Unfortunately, the model relies on several assumptions that do not always come to fruition in the real world.
Let's break down what that means and how you can perform better DCF analysis with the right discounted cash flow model.
Discounted cash flow (DCF) refers to valuation techniques that estimate the value of an investment based on predicted future cash flows.
DCF analysis seeks to determine an investment's value today based on a forecast of how much money it will generate in the future. These analyses help executive leadership to make better business decisions. Discounted cash flow analysis also helps business owners and managers determine capital budgets and operating expenses.
Let's take a moment to review the three main components of the DCF model.
The discounted cash flows can come from any source, such as profits, dividends or sales of assets. For example, if a firm wants to invest in new technology, the cash flow from that investment could be the income generated from the sale of those technology products or periodic stakeholder payouts. A cash flow report will enable you to track these profits.
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Source: Vena
The discount rate is the rate that future cash flows get discounted to their present value. We recommend setting the discount rate at the rate of return requested by the investor--the minimum return required for them to invest in the company.
You can also set the discount rate to the weighted average cost of capital (WACC). The WACC is the average of a company's cost of equity and its debt.
This element within the calculation is the number of years in which analysts expect these cash flows to occur. Often set to 10 years, the life expectancy of most companies, we recommend setting this to 15 or 20 years.
DCF analysis considers the time value of money in compounding settings. Once you have completed the future cash flows and set the discount rate, you will need to calculate the DCF. Use the formula below to calculate the DCF.
DCF = CF1 ÷ (1 + r)2 + CF2 ÷ (1 + r)2 + CF3 (1 + r)2 + CFn (1 + r)2
where:
CF1 = The cash flow for year one
CF2 = The cash flow for year two
CF3 = The cash flow for year three
CFn = The cash flow for additional years
The CFn value should include estimated cash flows and terminal values - ÔøΩ - ÔøΩfor the period. The formula is very similar to calculating the net present value (NPV), which sums the present value of future cash flows. The only difference is that the initial investment does not get deducted from the DCF model.
When performing DCF analysis or building DCF models, you have to consider all sides of the equation. We've prepared a list of advantages and disadvantages you need to know.
Discounted cash flow analysis can provide investors and companies with information on whether planned investments are worthwhile. It's an analysis that provides reasonable estimates of future cash flows. You can apply it to a wide variety of investment and capital projects.
You can adjust that forecast to provide results for various what-if scenarios to help you and your team consider different possible predictions.
The main limitation of DCF analysis is that it is an estimate rather than an actual number. Therefore, the DCF results are also estimates.
What that means is that for your DCF to be beneficial, individual investors and firms need to estimate discount rates and cash flows correctly. In addition, future cash flows will depend on various factors, including:
We cannot quantify them exactly, so investors should understand this inherent drawback in their decision making. Robust estimates are possible, but we should not necessarily rely solely on DCF.
Firms and investors should also evaluate other well-known elements, such as expected return, scalability and exit strategies, when assessing investment opportunities. In addition, equivalent business analysis and asset-based are two additional standard valuation methods.
Vena Cash Flow Planning Software empowers your finance leaders to create driver-based models you can run monthly, weekly or daily. Already have a model you and your teams know and love to use? No problem.
With Vena, you can create direct or indirect cash flow statements using existing Excel templates for financial reporting. This enables you to navigate business decisions and prepare for any scenario quickly and confidently.
Put your money to work. Manage cash flows effectively to predict long-term cash needs and pay off debts. Understand what drives your cash flow and set goals to plan for future investments proactively.
Request a demo to see if our award winning FP&A platform is right for you.
Schedule DemoOlivia MacDonald is a Senior Manager of FP&A at Vena. A creative problem solver who enjoys analyzing and detangling complex situations to make things better, she’s experienced in leading multiple projects at once and has found the key to success to be documentation, communication and teamwork. Olivia is passionate about removing manual, clunky and repetitive tasks from finance professionals’ working days so they can focus on what they believe truly adds value to the business instead. At work, she’s also heavily involved with Vena’s Women+ employee resource group, which collaborates with thought leaders and companies across the globe to remove intersectional barriers in the workplace. Outside of work, Olivia also takes part in youth engagement and education programs as a volunteer.
