Econ Grapher

DCF - Discounted Cash Flow 

What is a DCF model, or DCF analysis?
In DCF (Discounted Cash Flow) analysis the projected cash flows of a project are valued based on the time value of money concept (i.e. a dollar today is worth more than a dollar tomorrow). DCF analysis is also referred to as Net Present Value or NPV analysis, and will most often involve the building of a financial model in a program such as excel in order to calculate the future cash flows. The NPV or DCF methodology is widely used in investments and business and is a core valuation tool. The process involves determining initial and ongoing capital expenditure or investment in the business or project, and forecasting the cash expenses and revenues of the project (breaking this down to free cash flows - i.e. cash flows that are available to the owner), the cash flows are then discounted at an appropriate discount rate and summed up to produce a net present value (which may be divided by the number of shares in order to obtain a share price valuation).

How does it relate to Markets?
DCF analysis is widely used in investment banking and investment management. Thus as an investor you need to be aware of its use, it can be used to derive a fundamental valuation of a stock - and this can be very useful in value based investing (i.e. value the company, and see if the market price is above or below the valuation - if so then why? if for no valid reason then you could take a position that seeks to gain from and eventual reversion to valuation). It is also important to note that many broker research reports use DCF analysis to come up with a stock price valuation. 

Discount rate
The discount rate used is of vital importance, slight changes in the discount rate can have a huge impact on the valuation output. Typically a project or business WACC will be calculated based on the cost of debt and the cost of equity (which implicitly captures the risk of the business/project). In some cases it will be impossible or too difficult to obtain a scientifically based WACC or discount rate, in these circumstances you should use a WACC that is in line with the risk of the project. For example the risk free rate assumes the cash flows are risk free - this could therefore only be used to perform a DCF analysis on something like a government bond, so in thinking about which rate to use start with looking at the discount rate and then adding on a risk premium. A lot of companies will use a plucked out of the air figure of 12%, and this is probably a fair rate for most established businesses. For start-up projects or risky ventures discount rates of 15%, 20% or even 30% may be appropriate in some circumstances.

Terminal value
A terminal value is often used for the fact that it is often impractical to forecast out more than e.g. 5 years. It may also be planned to exit the project or business within a certain time frame e.g. through an IPO, trade sale, or buyout by partners - in this case it will be very important to include this final value in determining the merits of the project or investment proposal. The standard method of calculating terminal value is to take the net cash flow in e.g. year 5, e.g. $100 and grow it by a terminal growth rate e.g. 5%, and then divide this by the difference between the discount rate e.g. 15% and the terminal growth rate e.g. 5%, thus in this example the terminal value would be $1,050... of course this would also need to be discounted, so the present value would be $522.04 i.e. [1050/(1+0.15)^5].

Sources and further reading:
Value Based Management.net - DCF method
Solution Matrix - DCF/NPV/PV/FV analysis
Investopedia - DCF Analysis: Introduction
The Street - Getting started with discounted cash flows
Discounted Cash Flow by Kruschwitz & Loffler
IFA - Project Appraisal Using Discounted Cash Flow

Graph Library:

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Original Source: http://www.econgrapher.com/encyclopedia-dcf.html

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