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.
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.
- When should you not use DCF?
It is best to avoid using a DCF valuation if the company or asset has unstable or unpredictable cash flows.
- What is the difference between NPV and DCF?
The NPV or net present value compares the value of the investment amount today to its value in the future. DCF or discounted cash flow analyses an investment and determines how valuable it will be in the future. The DCF method mainly helps to gauge how long it will take to get returns from an investment.
- What is the fair value of an investment?
Fair value is a measure of an asset’s real worth as determined by buyers and sellers in a market. This is different from market value.
- Where should a beginner invest?
Beginners can invest in low-risk investment options such as bank deposits, fixed income mutual funds, PPF, etc.
- What are the three steps in investment analysis?
The three steps in investment analysis are identifying an investment opportunity, finding the present value of the future cash flows, and comparing the present value of the cash flows to the cost of the investment.