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Importance of learning discounted cash flow

Importance of learning discounted cash flow

Understanding the Discounted Cash Flow (DCF) method and all the benefits it can bring to business owners and their business goals could take businesses a step further towards greater expansion opportunities in the future. Read on to learn more about the DCF method.

Understanding and aptly utilising the Discounted Cash Flow (DCF) method as a business owner or manager will help them get ahead of the competition and prepare and plan better for future business eventualities and opportunities, and stay on top.

The DCF is a valuation method used by experts and professionals in the finance and investment world to figure out the actual worth of an investment.

The DCF analysis utilises informed projections of future free cash flows and discounts them to determine a present value, which will then be used in assessing the potential for an investment. A good investment opportunity is usually indicated by a resulting value—arrived at through the analysis—higher than the cost of the investment.

The process of designing a DCF model includes:

  • Projecting the future cash flows
  • Calculating and choosing discount rate
  • Discounting future cash flows
  • Estimating terminal value
  • Determining the net present value

Projecting the future cash flows

A stock’s value, and thus power, is equal to the overall present value of its future cash flows—this is the logic behind every DCF model. Sounds simple in theory, yes, but applying this logic in a real-life business situation is where the trick lies. This is why business owners need to thoroughly understand it to maximise on its future benefits on their business.

Projecting and estimating the future cash flows of a business is the first step to valuing any stock and commencing the DCF model application. Several factors are considered in the valuation process, depending on the company’s specific business situation, but in general, the most important factors include future sales growth and profit margins.

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Take note that in the projection of said factors the simple extrapolation of current trends into the future isn’t the way to go—in fact, this is ill-advised and will lead business owners to believing a stock is worth more or less than it actually is.

It is also necessary to consider industry trends, relevant economic data, and the company’s competitive edge when business owners start forecasting revenue growth. A company with an economic moat, or strong competitive advantages, has the tendency to grow faster than the rest of its competition—if it is taking the lion’s share of the market.

In addition, business owners also need to look into the business’ customers and suppliers to effectively commence the DCF analysis.

Calculating and choosing discount rate

After a well-informed projection of the company’s cash flows, business owners will then discount said future cash flows to the present for the money’s time value. For example, to determine the present value of AU$1 of future cash flow, divide said future cash flow by the appropriate multiplier, as in:

Current value of cash flow in number of years in the future = cash flow (CF) at number of years in the future / (1+R) ^ number of years in the future.

Where R is the discount rate or required return.

Business owners will find that when a cash flow is further out, the less it is worth in the present time’s Australian Dollars, or any involved currency specific to their business situation. Bear in mind too that the rate of return used to discount the future cash flow is inversely proportional to the present value. Thus, the higher the rate of return, the lower the present value.

Discounting future cash flows

Business owners need to determine whether they employ a simple/standard discount period, or the mid-year discount. The mid-year discount uses the following formula:

Cash flow / (1 + discount rate) ^ ((year - current year)-0.5)

Take note that the mid-year discount formula accounts for the reality that the cash flow gets in over the course of the full year, and not only by the end of the year, as assumed by the standard discount formula:

Cash flow / (1 + discount rate) ^ (year - current year)

Which simply assumes that the cash flow only comes in by year-end of any given year, and not during the entirety of its course.

Business owners must also be able to identify which discount formula works or applies best to their business situation. They can always engage the services of a qualified and trusted professional should they need further clarification.

Estimating terminal value

It is important for business owners to understand that they simply cannot estimate cash flows in perpetuity. This is why they need to adopt a general closure imposition in the discounted cash flow valuation.

This can be done by completing the cash flows estimation sometime in the foreseeable future and then calculating an end value, the terminal value, reflective of the company’s worth at a specific point in time.

Generally, there are three ways to find the terminal value:

  1. Assuming asset liquidation of the company involved by year-end, then estimating how much it would probably be paid for
  2. Valuing the business as a going concern at the time of terminal value estimation, applying a multiple to revenues, book value, or earning to come up with a valuation by the year-end
  3. Valuing the business also as a going concern still at the time of terminal value estimation, but assuming that the company’s cash flows are growing at a constant rate in perpetuity—thus, an assumption of stable growth (with an assumption of stable growth, the terminal value can be arrived at via a perpetual growth analysis/model)

Determining the net present value

Arriving at a terminal value, business owners will now proceed with determining the net present value. Discount the terminal value and then add to the total, or overall sum, of the discounted cash flow values—they may apply the Weighted Average Cost of Capital (WACC) or the simple percentage method.

The WACC is the metric to measure the cost of capital to a business or company. It finds great utilisation in the provision of a discount rate for mostly financed projects and ventures of similar nature.

To calculate the WACC, use the following formula:

(% of finance that is equity x cost of equity) + (% of finance that is debt x cost of debt) x (1 - tax rate).

Remember, however, that the application of the DCF method varies depending on the investment type in the valuation process. The most popular, and generally the three categories that often utilise the DCF method are:

  • Bonds
  • Stocks
  • Real estate

Bonds

The use of discounted cash flows is central to all bond valuation processes. The numbers are more concrete when it comes to bonds, as bonds themselves are considered giant DCF engines in their established features. Variables including future cash flows, periods, and discount rate are all given and are generally unchanging.

Stocks

DCF is certainly a popular tool in stocks valuation. Unlike bonds, however, stocks include an added organic element—their numbers are dynamic, active, and always changing. Note that in the calculation of discounted cash flows on stocks, business owners must foresee and prepare for added risk(s).

Real estate

DCF is also very popular in real estate. For business owners thriving within the industry of buy-and-sell of properties or buying properties, renovating them, and then selling them for profit, they may consider the use and advantage of DCF calculations in their business decisions.

Understanding the DCF method, its entailing analyses, processes, and business implications offers a lot of advantages, including:

  • Being certain about the use of an effective and reliable valuation method
  • A “progressive” evaluation system
  • An introspective method
  • A cash flow generation-focused system
  • Aptly considering operating strategies a valuation factor
  • Valuation of business synergies individually

Effective and reliable valuation method

The DCF is considered by most experts as, theoretically, the most sound and realistic valuation method there is.

More progressive

Since it is forward-looking, the DCF assures reliable results in its analyses by evaluating informed future expectations, rather than relying on obsolete and dubious historical records (that may very well not apply to the ever-changing global economic realities).

Introspective

Because it is also inward-looking, the DCF method ensures quality business-specific results, as it relies more on core expectations of the company or its assets than on the influences of very volatile extraneous variables.

Cash flow generation-focused

The DCF method and its entailing analyses are less affected by—and thus not concerned too much on—accounting assumptions and standard practices (that may very well be obsolete due to economic dynamism). Rather, the DCF analysis is focused on cash flow generation.

Considers operating strategies a valuation factor

Various and expected operating strategies are allowed and accounted for in the DCF method, and are all factored in the valuation process.

Business synergies valued individually

All business components are looked into, assessed, and valued as separate entities, allowing for a more rigorous and specific, if not precise, valuation process.

Understanding the DCF and all its entailing processes, as well as considering its results in the business decision-making process no doubt equips business owners to prepare better not only for unwanted eventualities but for great business opportunities ahead.

If unsure/unclear about some of its specifics, business owners are advised to talk to their trusted accountant or any relevant professional with a proven expertise in the DCF method and its great benefits on their business and business goals.

Importance of learning discounted cash flow
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