Businesses typically make their decisions based on dollars and cents. Are the potential earnings more than the cost? Then it’s a net positive and it should be done.
But how do you measure potential earnings? And more importantly, what if those earnings are far in the future? Are you willing to spend money now for cash flow a year in the future? What about five?
All of a sudden, that decision isn’t as simple as one number being bigger than the other.
That’s why businesses use discounted cash flow to simplify decision-making without having to juggle all of these considerations.
What is discounted cash flow? (DCF)
Discounted cash flow is a way of measuring the present value of potential future cash flow from an investment or business activity. What differentiates it from other approaches is it puts a greater amount of value on sooner cash flow than later.
Money right now is worth more than money in the future because, the sooner money is in your hands, the sooner it can be used in other investments or revenue-generating activities. This is called the “time value of money.”
For example, consider two opportunities: one pays $10,000 after a year, and the other pays $15,000 after two years.
With the $10,000 in hand at the end of year one, you could potentially invest in advertising or purchase a new piece of equipment that makes your operations more efficient. If these further investments generate more than $5,000 by the end of year two, the first option generates more value.
The discounted cash flow valuation model estimates the potential value of where you invest money in your business to capture the added value of having cash in hand sooner.
What does it mean to discount cash flow?
Discounted cash flow works by projecting future cash flows and then “discounting” them to a present value.
The discount rate works similarly to an interest rate but in reverse. Rather than increasing the present value of an investment every year into the future, it discounts the future value into an estimate of its present value.
The further into the future cash flow is, the more it’s discounted in its present value.
Using the discounted cash flow method to calculate the present value of different options of investment allows for a streamlined comparison. By comparing the present value of the two options, your decision is simplified to which present value is higher.
Calculating discounted cash flow and choosing a discount rate is based on assumptions set about how the business operates. Because of this, it’s best to use the discounted cash flow calculation for time periods of up to five years—beyond that, the assumptions might not hold up.
Components of the DCF formula
To understand the formula on a deeper level, let’s break it down into each component used in the calculation.
Discount rate
The discount rate acts like an interest rate in the discounted cash flow formula.
The purpose of the discount rate is to represent the opportunity cost of how you use your money. Opportunity cost is the value you miss out on by choosing one option over another.
Businesses choose their discount rate. There’s no one “right” way to calculate your discounted rate, but some methods are more common than others.
A popular choice is to use the weighted average cost of capital (WACC). This calculation uses the cost of equity, the cost of debt, and the cost of preferred stock to represent the desired return on investment (ROI) to be net positive.
Alternatively, choose a rate that reflects what you would otherwise use your money on. Some examples of what you could use as a discount rate are:
- The US risk-free rate of return (which has hovered between 3% and 5%)
- The US federal discount rate (currently set at 5.50%)
- The interest rate on a savings account or other investment
- An estimate as identified with an accountant or finance professional
Ultimately, discounted DCF is intended to be an estimate. Your discount rate doesn’t need to be perfect, but you should be consistent in what you’re using and re-evaluate its efficacy over time.
Cash flow for the period
Cash flow for the period is the money you expect the investment to generate at that point in the future.
Estimating cash flow is an imperfect art. It’s important to look at data from inside and outside of your business to get the most accurate estimate of cash flow generation.
In particular, base your cash flow estimates on:
- Historical trends: What has been the approximate cash flow impact from similar actions in the business? For example, look at a prior advertising campaign or product launch to estimate the added value of a new one.
- Industry trends: How is the market expected to change in the coming months or years? Is value expected to increase or decrease?
- Customer trends: How has the spending activity of your customer base changed over time? At what rate are new customers entering the picture?
- Other company initiatives: Are any other growth or expansion initiatives being taken at the same time that may impact cash flow?
- Economic conditions: How is the spending of the population trending?
- Scenario analysis: What are the best, worst, and base expectations? It’s worth going through the DCF process for each.
You could spend a nearly endless amount of time perfecting your cash flow forecast. A quick estimate may be just as effective as an in-depth analysis, but it ultimately comes down to how comprehensive you want the estimate to be.
Number of periods
The number of periods is based on two factors:
- How far into the future are you discounting for?
- What time period are you using?
The typical time periods used in DCF calculations are months, quarters, or years.
Choose a time period that makes sense given the timeframe of the project. If the investment is expected to pay off within a year, it makes sense to use months or quarters in the discounting calculation.
Remember that if your discount rate is based on a year, it needs to be adjusted for alternative periods. This means dividing the discount rate by 12 for months or 4 for quarters.
As a general rule of thumb, the further out you’re discounting, the less accurate your calculation will be. This is because the assumptions the calculation is based on may change over that time frame.
Terminal value
Terminal value is the expected cash flow that exists beyond the forecasted time periods. For example, if you are running a DCF calculation for the next year, the terminal value is the expected cash flow for every year past that.
To estimate the terminal value, businesses often use the Gordon Growth Model (or Perpetuity Growth Model).
The Gordon Growth Model formula is:
Terminal Value = FCF * (1+g)(r-g)
Where:
- FCF is the free cash flow in the final projected time period
- g is the perpetual growth rate of cash flows (the rate of inflation or growth rate of GDP are most commonly used)
- r is your chosen discount rate
When making a long-term projection, terminal value is an essential way of simplifying the calculation while maintaining the same level of insight and value.
However, if you’re projecting for a short or specific time period, it’s best to use the DCF for each time period rather than use a terminal value.
As an example, if you’re only interested in the forecasted cash flow for the next three years, use the DCF without a terminal value.
Discounted cash flow formula
The discounted cash flow formula looks like this:
DCF = CF1(1+r)1+CF2(1+r)2+ ... + CFn(1+r)n
Where:
- CF = Cash Flow for the period
- r = Discount rate (also known as the required rate of return)
- n = Number of periods
In some cases, an additional value is included in the calculation: the terminal value.
The terminal value represents the value of all future cash flows beyond the period you’re projecting. It’s worthwhile to include if you’re projecting cash flow far into the future.
Example: How to calculate discounted cash flow
A clothing manufacturer is launching a new athletic shirt. They’re currently considering two different marketing campaigns for the launch: hire influencers to promote the product through social media or run ads on television.
The expectation is that the influencer promotion would drum up the most activity in the short term, but have a short overall lifespan.
Comparatively, television ads would take time to be effective but have a longer overall lifespan.
To decide which path to take, the business will choose the option with the greater cash impact over the next year, broken up into quarters.
They start by forecasting expected cash flow by quarter based on past marketing initiatives.
The expected total revenue is higher for the television ads than the influencer push. But the company values money now more than money later, so they opt to use the discounted cash flow calculation to get a better comparison.
For a discount rate, the business has calculated its WACC as 8%. Since this is an annual number and they’re looking at quarters, they divide by four to get a discount rate of 2%.
They input each period into the DCF calculation for the influencer push:
DCF = 400,000(1+0.02)1+50,000(1+0.02)2+25,000(1+0.02)3+25,000(1+0.02)4
DCF =392,156.86+48,058.44+23,558.06+23,096.14=486,869.50
Then again for the television ads:
DCF = 30,000(1+0.02)1+80,000(1+0.02)2+150,000(1+0.02)3+250,000(1+0.02)4
DCF =29,411.76 +76,893.50+141,348.35+230,961.36=478,614.97
To make the comparison crystal clear, they compile both into a single table:
Even though the television ads would generate more cash flow over the year, the influencer is pushed because of how much more cash it generates in the short term versus the long term.
Pros and cons of discounted cash flow analysis
While discounted cash flow analysis helps with making business decisions, there are caveats to keep in mind while using it. Enjoy the benefit of the pros, but keep in mind how some of the cons may affect your analysis.
Pros
- Easily adjustable: The equation can be used with different cash flow estimates or discount rates to test different scenarios.
- Applicable to many situations: DCF isn’t just for investments, it can be used in decision-making big and small like which client to take on, which good or services to focus on, or which advertising strategy to pick.
- Better decision-making: By capturing the time value of money, DCF projections more accurately guide you to the decisions that have the best impact on your business.
Cons
- Based on estimates: Like all forecasts, discounted cash flow is based on estimates and assumptions. If those estimates or assumptions are proven to be false or change over time, the calculation is nullified.
- Complex datasets and calculations: The DCF calculation isn’t plug-and-play, you need to do some complex work to find each component. Consider working with a finance professional to set the groundwork you can build off of.
- Doesn’t suit long-term forecasts: The further you look into the future, the more likely it is that an assumption will fall apart. If you’re looking to forecast far into the future, be sure to update your projection with new information.
Optimize your data for DCF and more
Whether it’s DCF or other business forecasting, the quality of your projection hinges on the quality of your historical data.
The tools you use and the ways you compile your data are invaluable components of your forecasting practices. By investing in the tools you use, you’ll save time and improve the quality of the work you do.
If you’re looking to make DCF a regular practice in your operations, its worthwhile to consider investing in the software, tools, and practices you use daily. This data will be the bedrock of the assumptions your DCF model is built off of.
With BILL, you get crystal clarity into your financial history and automatic forecasts that can be used to improve your decision-making. Reach out for a demo to see BILL in action.
FAQ
Is DCF the same as NPV?
Discounted cash flow (DCF) and net present value (NPV) are similar calculations. Both are used in cost-benefit analysis, but the NPV calculation includes an additional step.
After calculating the DCF, simply subtract the upfront cost to get the NPV.
For example, if the DCF of an investment is $500 and the initial cost is $300, then the NPV is $200 (500 - 200).
This makes the NPV calculation better suited when comparing options with different upfront costs. By capturing the difference in costs, you can use NPV to compare the options at a glance and make an informed decision.
How do you estimate future cash flows for DCF?
To estimate future cash flows, start by looking at your historical data.
Look for a similar change or investment you’ve made in the past that will help you estimate the impact of the options you’re considering. It’s also worth reaching out to people in your network to hear about their experiences if you don’t have your own to draw from.
Ultimately, estimating cash flows is an imperfect practice. Try using a best-case, base-case, and worst-case scenario estimate to cover your bases and see all possible outcomes.
When is DCF analysis most appropriate to use?
DCF analysis is most appropriate to use on decisions with a long-term impact. Generally speaking, you should be looking at a forecast window of one to five years.
The cash flow impact should also be sufficient enough to warrant discounting. If the potential impact is in the tens or hundreds of dollars, discounting isn’t going to massively impact the present value.
Why is the terminal value important in DCF analysis?
The terminal value helps capture the long-term value of the investment without overcomplicating the calculation.
If you’re considering a change that has an impact in perpetuity, you could theoretically keep discounting each future period until the end of time. But a better practice (and use of your time) is to use a terminal value to represent a perpetual impact.
