Discounted cash flow - Wikipedia, the free encyclopedia

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From Wikipedia, the free encyclopedia

In finance, the discounted cash flow (DCF) approach describes 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 to give their
present values. The discount rate used is generally the appropriate
Weighted average cost of capital (WACC), that reflects the risk of the
cashflows. The discount rate reflects two things:
1. the time value of money (risk-free rate) - investors would rather have
cash immediately than having to wait and must therefore be compensated
by paying for the delay.
2. a risk premium (risk premium rate) - reflects the extra return investors
demand because they want to be compensated for the risk that the cash
flow might not materialize after all.

Excel spreadsheet uses Free

cash flows to estimate stock's
Fair Value and measure the
sensibility of WACC and
Perpetual growth

Discounted cash flow analysis is widely used in investment finance, real estate development, and corporate
financial management.
Very similar is the net present value.

1 History
2 Mathematics
2.1 Discrete cash flows
2.2 Continuous cash flows
3 Example DCF
4 Methods of appraisal of a company or project
5 History
6 See also
7 References
8 External links
9 Further reading

In 1938, John Burr Williams was the first to formally articulate the DCF method in a working paper released
with the title "The Theory of Investment Value".

Discrete cash flows

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The discounted cash flow formula is derived from the future value formula for calculating the time 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 flow (FV), or FV adjusted for the delay in
receipt;
FV is the nominal value of a cash flow amount in a future period;
i is the interest 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;
d is the discount rate, which is i/(1+i), ie the interest rate expressed as a deduction at the beginning of
the year instead of an addition at the end of the year;
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 for i, that is the internal rate of return.
All the above assumes that the interest rate remains constant throughout the whole period.

Continuous cash flows

For continuous cash flows, the summation in the above formula is replaced by an integration:

where FV(t) is now the rate of cash flow, and = log(1+i).

To show how discounted cash flow analysis is performed, consider the following simplified 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.

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1.1453 x 100000 = 150000 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, that means that the value of $150,000 received in three years actually has a
present value of $129,576 (rounded off). Those future dollars aren't worth the same as the dollars we have
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
(14.5%-5.0%)/(100%+5%) or approximately 9.0% (still very respectable). (As a check, 1.050 x 1.090 =
1.145 approximately.)
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, of course). There is of course a lot of uncertainty about house
prices, and the outturn 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. See Capital asset pricing model
for 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 (9.0%-5.0%)/(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 in five years, then
on the above assumptions buying the house would actually cause John to lose 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 make a profit in

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discounted terms even if 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.

This is necessarily a simple treatment of a complex subject: 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 value approach (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 a "risk-free" rate
Weighted average cost of capital approach (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.

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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.[1]

Discounted cash flow calculations have been used in some form since money was first lent at interest in
ancient times. As a method of asset valuation it has often been opposed to accounting book value, which is
based on the amount paid for the asset. 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 expressed the
DCF method in modern economic terms.

Adjusted present value

Capital asset pricing model
Capital budgeting
Cost of capital
Economic value added
Enterprise value
Internal rate of return

Free cash flow

Financial modeling
Flows to equity
Market value added
Weighted average cost of capital
Net present value
Valuation using discounted cash flows
Time value of money

1. ^ Pratt, Shannon; Robert F. Reilly, Robert P. Schweihs (2000). Valuing a Business (http://books.google.com
/books?id=WO6wd8O8dsUC&printsec=frontcover&dq=shannon+pratt&ei=fcfUR6q-F4TCyQSrxfWABA&
sig=Fpqt8pGRjbLPZJ9e_QEQGFzQ7y0#PPA913,M1) . McGraw-Hill Professional. McGraw Hill. ISBN
0071356150. http://books.google.com/books?id=WO6wd8O8dsUC&printsec=frontcover&dq=shannon+pratt&
ei=fcfUR6q-F4TCyQSrxfWABA&sig=Fpqt8pGRjbLPZJ9e_QEQGFzQ7y0#PPA913,M1.

Continuous compounding/cash flows (http://ocw.mit.edu/NR/rdonlyres/Nuclear-Engineering

/22-812JSpring2004/67B1788B-6ADC-45A6-B85A-54D13B2F537F/0/lec03slides.pdf)
The Theory of Interest (http://www.econlib.org/library/YPDBooks/Fisher/fshToI.html) at the Library
of Economics and Liberty.
Monography about DCF (including some lectures on DCF) (http://www.wacc.biz) . Wacc.biz
Foolish Use of DCF (http://www.fool.com/news/commentary/2005/commentary05032803.htm) .
Motley Fool.
Getting Started With Discounted Cash Flows (http://www.thestreet.com/university/personalfinance
/10385275.html) . The Street.
International Good Practice: Guidance on Project Appraisal Using Discounted Cash Flow
(http://www.ifac.org/Members/DownLoads/Project_Appraisal_Using_DCF_formatted.pdf) ,
International Federation of Accountants, June 2008, ISBN 978-1-934779-39-2
Equivalence between Discounted Cash Flow (DCF) and Residual Income (RI) (http://papers.ssrn.com
/sol3/papers.cfm?abstract_id=381880) Working paper; Duke University - Center for Health Policy,
Law and Management

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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.
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