Discounted cash flow

In finance, discounted cash flow (DCF) analysis is a method of valuing a project,

company, or asset using the concepts of the time value of money. All future cash
flows are estimated and discounted by using cost of capital to give their present
values (PVs). The sum of all future cash flows, both incoming and outgoing, is the
net present value (NPV), which is taken as the value of the cash flows in question.[1]

Using DCF analysis to compute the NPV takes as input cash flows and a discount
rate and gives as output a present value. The opposite process takes cash flows and a
price (present value) as inputs, and provides as output the discount rate; this is used
in bond markets to obtain theyield.
Spreadsheet uses Free cash flows to
Discounted cash flow analysis is widely used in investment finance, real estate estimate stock's Fair Value and
development, corporate financial management and patent valuation. It was used in measure the sensibility ofWACC and
industry as early as the 1700s or 1800s, widely discussed in financial economics in Perpetual growth
[2]
the 1960s, and became widely used in U.S. Courts in the 1980s and 1990s.

Contents
Discount rate
History
Mathematics
Discounted cash flows
Continuous cash flows
Example DCF
Methods of appraisal of a company or project
Equity-approach
Entity-approach
Shortcomings
Doesn't account for all variables
Integrated Future Value (IntFV)
See also
References
Further reading
External links

Discount rate
The most widely used method of discounting is exponential discounting, which values future cash flows as "how much money would
have to be invested currently, at a given rate of return, to yield the cash flow in future." Other methods of discounting, such as
hyperbolic discounting, are studied in academia and said to reflect intuitive decision-making, but are not generally used in industry
.

The discount rate used is generally the appropriate weighted average cost of capital (WACC), that reflects the risk of the cash flows.
This WACC can be found using Perry's calculation model which was developed in 1996. The discount rate reflects two things:
 1. Time value of money (risk-free rate) – according to the theory oftime preference, investors would rather have cash
immediately than having to wait and must therefore be compensated by paying for the delay
2. Risk premium – reflects the extra return investors demand because they want to be compensated for the risk that the
cash flow might not materialize after all

History
Discounted cash flow calculations have been used in some form since money was first lent at interest in ancient times. Studies of
ancient Egyptian and Babylonian mathematics suggest that they used techniques similar to discounting of the future cash flows. This
method of asset valuation differentiated between the accounting book value, which is based on the amount paid for the asset.[3]
Following the stock market crash of 1929, discounted cash flow analysis gained popularity as a valuation method for stocks. Irving
Fisher in his 1930 book The Theory of Interest and John Burr Williams's 1938 text The Theory of Investment Value first formally
[4]
expressed the DCF method in modern economic terms.

Mathematics

Discounted cash flows

The discounted cash flow formula is derived from the future value formula for calculating thetime value of money and compounding
returns.

Thus the discounted present value (for one cash flow in one future period) is expressed as:

where

DPV is the discounted present value of the future cash flowFV), ( or FV adjusted for the delay in receipt;
FV is the nominal value of a cash flow amount in a future period;
r is the interest rate or discount rate, which reflects the cost of tying up capital and may also allow for the risk that the
payment may not be received in full;[5]
n is the time in years before the future cash flow occurs.
Where multiple cash flows in multiple time periods are discounted, it is necessary to sum them as follows:

for each future cash flow (FV) at any time period (t) in years from the present time, summed over all time periods. The sum can then
be used as a net present value figure. If the amount to be paid at time 0 (now) for all the future cash flows is known, then that amount
can be substituted for DPV and the equation can be solved forr, that is the internal rate of return.

All the above assumes that the interest rate remains constant throughout the whole period.

If the cash flow stream is assumed to continue indefinitely, the finite forecast is usually combined with the assumption of constant
cash flow growth beyond the discrete projection period. The total value of such cash flow stream is the sum of the finite discounted
cash flow forecast and theTerminal value (finance).
Continuous cash flows
For continuous cash flows, the summation in the above formula is replaced by an integration:

where is now the rate of cash flow, and .

Example DCF
To show how discounted cash flow analysis is performed, consider the following example.

John Doe buys a house for $100,000. Three years later, he expects to be able to sell this
house for $150,000.

Simple subtraction suggests that the value of his profit on such a transaction would be $150,000 − $100,000 = $50,000, or 50%. If
that $50,000 is amortized over the three years, his implied annual return (known as the internal rate of return) would be about 14.5%.
Looking at those figures, he might be justified in thinking that the purchase looked like a good idea.

1.1453 x $100,000 = $150,000, approximately.

However, since three years have passed between the purchase and the sale, any cash flow from the sale must be discounted
accordingly. At the time John Doe buys the house, the 3-year US Treasury Note rate is 5% per annum. Treasury Notes are generally
considered to be inherently less risky than real estate, since the value of the Note is guaranteed by the US Government and there is a
liquid market for the purchase and sale of T-Notes. If he hadn't put his money into buying the house, he could have invested it in the
relatively safe T-Notes instead. This 5% per annum can, therefore, be regarded as the risk-free interest rate for the relevant period (3
years).

Using the DPV formula above (FV=$150,000, i=0.05, n=3), that means that the value of $150,000 received in three years actually
has a present value of $129,576 (rounded off). In other words, we would need to invest $129,576 in a T-Bond now to get $150,000 in
3 years almost risk-free. This is a quantitative way of showing that money in the future is not as valuable as money in the present
($150,000 in 3 years isn't worth the same as $150,000 now; it is worth $129,576 now).

Subtracting the purchase price of the house ($100,000) from the present value results in the net present value of the whole
transaction, which would be $29,576 or a little more than 29% of the purchase price.

Another way of looking at the deal as the excess return achieved (over the risk-free rate) is (114.5 - 105)/(100 + 5) or approximately
9.0% (still very respectable).

But what about risk?

We assume that the $150,000 is John's best estimate of the sale price that he will be able to achieve in 3 years time (after deducting all
expenses). There is a lot of uncertainty about house prices, and the outcome may end up higher or lower than this estimate.

(The house John is buying is in a "good neighborhood," but market values have been rising quite a lot lately and the real estate
market analysts in the media are talking about a slow-down and higher interest rates. There is a probability that John might not be
able to get the full $150,000 he is expecting in three years due to a slowing of price appreciation, or that loss of liquidity in the real
estate market might make it very hard for him to sell at all.)

Under normal circumstances, people entering into such transactions are risk-averse, that is to say that they are prepared to accept a
lower expected return for the sake of avoiding risk. SeeCapital asset pricing modelfor a further discussion of this. For the sake of the
example (and this is a gross simplification), let's assume that he values this particular risk at 5% per annum (we could perform a more
precise probabilistic analysis of the risk, but that is beyond the scope of this article). Therefore, allowing for this risk, his expected
return is now 9.0% per annum (the arithmetic is the same as above).

And the excess return over the risk-free rate is now (109 - 105)/(100 + 5) which comes to approximately 3.8% per annum.

That return rate may seem low, but it is still positive after all of our discounting, suggesting that the investment decision is probably a
good one: it produces enough profit to compensate for tying up capital and incurring risk with a little extra left over. When investors
and managers perform DCF analysis, the important thing is that the net present value of the decision after discounting all future cash
flows at least be positive (more than zero). If it is negative, that means that the investment decision would actually
lose money even if
it appears to generate a nominal profit. For instance, if the expected sale price of John Doe's house in the example above was not
$150,000 in three years, but$130,000 in three years or $150,000 infive years, then on the above assumptions buying the house would
actually cause John tolose money in present-value terms (about $3,000 in the first case, and about $8,000 in the second). Similarly, if
the house was located in an undesirable neighborhood and the Federal Reserve Bank was about to raise interest rates by five
percentage points, then the risk factor would be a lot higher than 5%: it might not be possible for him to predict a profit in discounted
terms even if he thinks he could sell the house for$200,000 in three years.

In this example, only one future cash flow was considered. For a decision which generates multiple cash flows in multiple time
periods, all the cash flows must be discounted and then summed into a single
net present value.

Methods of appraisal of a company or project

This is offered as a simple treatment of a complexsubject. More detail is beyond the scope of this article.

For these valuation purposes, a number of different DCF methods are distinguished today, some of which are outlined below. The
details are likely to vary depending on the capital structure of the company. However the assumptions used in the appraisal
(especially the equity discount rate and the projection of the cash flows to be achieved) are likely to be at least as important as the
precise model used.

Both the income stream selected and the associated cost of capital model determine the valuation result obtained with each method.
This is one reason these valuation methods are formally referred to as the Discounted Future Economic Income methods.

Equity-approach
Flows to equity approach (FTE)

Discount the cash flows available to the holders of equity capital, after allowing for cost of servicing debt capital
Advantages: Makes explicit allowance for the cost of debt capital
Disadvantages: Requires judgement on choice of discount rate

Entity-approach
Adjusted present valueapproach (APV)

Discount the cash flows before allowing for the debt capital (but allowing for the tax relief obtained on the debt
capital)
Advantages: Simpler to apply if a specific project is being valued which does not have earmarked debt capital
finance
Disadvantages: Requires judgement on choice of discount rate; no explicit allowance for cost of debt capital,
which may be much higher than arisk-free rate
Weighted average cost of capitalapproach (WACC)

Derive a weighted cost of the capital obtained from the various sources and use that discount rate to discount the
cash flows from the project
Advantages: Overcomes the requirement for debt capital finance to be earmarked to particular projects
 Disadvantages: Care must be exercised in the selection of the appropriate income stream. The net cash flow to
total invested capital is the generally accepted choice.
Total cash flow approach (TCF)

This distinction illustrates that the Discounted Cash Flow method can be used to determine the value of various
business ownership interests. These can include equity or debt holders.
Alternatively, the method can be used to value the company based on the value of total invested capital. In each
case, the differences lie in the choice of the income stream and discount rate. For example, the net cash flow to
total invested capital and WACC are appropriate when valuing a company based on the market value of all
invested capital.[6]

Shortcomings
Commercial banks have widely used discounted cash flow as a method of valuing commercial real estate construction projects. This
practice has two substantial shortcomings. 1) The discount rate assumption relies on the market for competing investments at the time
of the analysis, which would likely change, perhaps dramatically, over time, and 2) straight line assumptions about income increasing
over ten years are generally based upon historic increases in market rent but never factors in the cyclical nature of many real estate
markets. Most loans are made during boom real estate markets and these markets usually last fewer than ten years. Using DCF to
analyze commercial real estate during any but the early years of a boom market will lead to overvaluation of the asset.

Discounted cash flow models are powerful, but they do have shortcomings. DCF is merely a mechanical valuation tool, which makes
it subject to the principle "garbage in, garbage out". Small changes in inputs can result in large changes in the value of a company.
Instead of trying to project the cash flows to infinity, terminal value techniques are often used. A simple perpetuity is used to estimate
the terminal value past 10 years, for example. This is done because it is harder to come to a realistic estimate of the cash flows as
.[7]
time goes on involves calculating the period of time likely to recoup the initial outlay

Another shortcoming is the fact that the Discounted Cash Flow Valuation should only be used as a method of intrinsic valuation for
companies with predictable, though not necessarily stable, cash flows. The Discounted Cash Flow valuation method is widely used in
valuing mature companies in stable industry sectors such as Utilities. At the same time, this method is often applied to valuation of
high growth technology companies. In valuing young companies without much cash flow track record, the Discounted Cash Flow
method may be applied a number of times to assess a number of possible future outcomes, such as the best, worst and mostly likely
case scenarios.

Doesn't account for all variables

Traditional DCF calculations only consider the financial costs and benefits of a decision and do not not fully "capture the short- or
long-term importance, value, or risks associated with natural and social capital"[8] because they do not integrate the environmental,
social and governance (ESG) performance of an organization. Without a metric for measuring the short and long term environmental,
social and governance performance of a firm, decision makers are planning for the future without considering the extent of the
impacts associated with their decisions.

Integrated Future Value (IntFV)

To address the lack of integration of the short and long term importance, value and risks associated
with natural and social capital into
the traditional DCF calculation, companies are valuing their environmental, social and governance (ESG) performance through an
Integrated Management approach to reporting that expands DCF or Net Present Value to Integrated Future Value. This allows
companies to value their investments not just for their financial return but also the long term environmental and social return of their
investments. By highlighting environmental, social and governance performance in reporting, decision makers have the opportunity
[9] The social cost of carbon is one
to identify new areas for value creation that are not revealed through traditional financial reporting.
value that can be incorporated into Integrated Future Value calculations to encompass the damage to society from greenhouse gas
emissions that result from an investment. This is an integrated approach to reporting that supports Integrated Bottom Line (IBL)
decision making, which takes triple bottom line(TBL) a step further and combines financial, environmental and social performance
reporting into one balance sheet. This approach provides decision makers with the insight to identify opportunities for value creation
that promote growth and change within an organization.[10]

See also
Adjusted present value
Capital asset pricing model
Capital budgeting
Cost of capital
Debt cash flow
Economic value added
Enterprise value
Financial modeling
Flows to equity
Free cash flow
Internal rate of return
Market value added
Net present value
Patent valuation
Residual Income Valuation
Time value of money
Valuation using discounted cash flows
Weighted average cost of capital

References
1. "Wall Street Oasis (DCF)"(http://www.wallstreetoasis.com/finance-dictionary/what-is-a-discounted-cash-flow-DCF).
Wall Street Oasis. Retrieved 5 February 2015.
2. Simkovic, Michael (2017). "The Evolution of V
aluation in Bankruptcy".American Bankruptcy Law Journal.
SSRN 2810622 (https://ssrn.com/abstract=2810622).
3. O.E.H. Neugebaner, The Exact Sciences in Antiquity (Copenhagen :Ejnar Mukaguard, 1951) p.33 (1969).O.E.H.
Neugebaner, The Exact Sciences in Antiquity(Copenhagen :Ejnar Mukaguard, 1951) p.33. US: Dover Publications.
p. 33. ISBN 0486223329.
4. Fisher, Irving. "The theory of interest."New York 43 (1930).
5. "Discount rates and net present value"(http://data.gov.uk/sib_knowledge_box/discount-rates-and-net-present-value).
Centre for Social Impact Bonds. Retrieved 28 February 2014.
6. Pratt, Shannon; Robert F. Reilly; Robert P. Schweihs (2000). Valuing a Business (https://books.google.com/books?id
=WO6wd8O8dsUC&printsec=frontcover&dq=shannon+pratt#PP A913,M1). McGraw-Hill Professional. McGraw Hill.
ISBN 0-07-135615-0.
7. "Discounted Cash Flow - DCF"(http://www.investopedia.com/terms/d/dcf.asp). investopedia.com. Retrieved
22 November 2010.
8. Sroufe, Robert (2018).Integrated Management: How Sustainability Creates V
alue for Any Business. Emerald
Publishing.
9. Eccles, Robert; Krzus, Michael (2010).One Report: Integrated Reporting for a Sustainable Strategy
. Wiley.
10. Sroufe, Robert (July 2017)."Integration and Organizational Change T
owards Sustainability" (https://www.researchgat
e.net/publication/318126290_Integration_and_Organizational_Change_T owards_Sustainability). Journal of Cleaner
Production. 162: 315–329 – via Research Gate.

Further reading
International Association of CPAs, Attorneys, and Management (IACAM)(Free DCF Valuation E-Book Guidebook)
 International Federation of Accountants (2007).Project Appraisal Using Discounted Cash Flow .
Copeland, Thomas E.; Tim Koller; Jack Murrin (2000). Valuation: Measuring and Managing the Value of Companies.
New York: John Wiley & Sons. ISBN 0-471-36190-9.
Damodaran, Aswath (1996). Investment Valuation: Tools and Techniques for Determining the Value of Any Asset.
New York: John Wiley & Sons. ISBN 0-471-13393-0.
Rosenbaum, Joshua; Joshua Pearl (2009).Investment Banking: Valuation, Leveraged Buyouts, and Mergers &
Acquisitions. Hoboken, NJ: John Wiley & Sons. ISBN 0-470-44220-4.
James R. Hitchnera (2006).Financial Valuation: Applications and Models. USA: Wiley Finance. ISBN 0-471-76117-
6.
Chander Sawhney (2012).Discounted Cash Flow –The Prominent Income Approach to a Vluation. INDIA: [1].
External link in |publisher= (help)

External links
Calculating Intrinsic Value Using the DCF Model
Calculating Terminal Value Using the DCF Model
Continuous compounding/cash flows
The Theory of Interestat the Library of Economics and Liberty.
Monography about DCF (including some lectures on DCF) .
Foolish Use of DCF. Motley Fool.
Getting Started With Discounted Cash Flows. The Street.
Equivalence between Discounted Cash Flow (DCF) and Residual Income (RI)
Working paper; Duke University -
Center for Health Policy, Law and Management

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