The Discounted Cash Flow (DCF) is calculated by summing the present value of projected future cash flows, including a terminal value, to arrive at an intrinsic value of an asset or company. The core DCF formula states that it is equal to the sum of the cash flow in each period divided by one plus the discount rate (WACC) raised to the power of the period number.
Understanding the DCF Formula
DCF analysis is a valuation method used to estimate the value of an investment based on its expected future cash flows. It involves discounting these future cash flows back to their present value using a discount rate, typically the Weighted Average Cost of Capital (WACC).
The fundamental formula for calculating DCF is as follows:
DCF = CF₁/(1+r)¹ + CF₂/(1+r)² + ... + CFn/(1+r)ⁿ + TV/(1+r)ⁿ
Where:
- CFₜ: The cash flow for a specific period (t).
- r: The discount rate (often WACC).
- t: The period number (e.g., year 1, year 2).
- n: The last period of the explicit forecast.
- TV: The Terminal Value, representing the value of cash flows beyond the explicit forecast period.
Breakdown of Formula Components
To calculate DCF accurately, it's essential to understand each component:
| Component | Description |
|---|---|
| Cash Flow (CFₜ) | Represents the free cash flow (FCF) expected to be generated by the company or asset in each future period. FCF is the cash a company generates after accounting for cash outflows to support operations and maintain its capital assets. It's often calculated as EBIT(1-Tax Rate) + Depreciation & Amortization - Capital Expenditures - Change in Working Capital. |
| Discount Rate (r) | This is the rate used to convert future cash flows into their present value. It reflects the time value of money and the risk associated with receiving those cash flows. The most common discount rate used in DCF is the Weighted Average Cost of Capital (WACC), which considers the cost of both equity and debt financing. |
| Period Number (t) | Indicates the specific year or period in which the cash flow is expected to occur. Each future cash flow is discounted based on how far in the future it is received. |
| Terminal Value (TV) | Represents the value of all cash flows beyond the explicit forecast period (typically 5-10 years). It assumes a stable growth rate for cash flows into perpetuity or a multiple of a financial metric. It can constitute a significant portion of the total DCF value. |
Step-by-Step DCF Calculation Process
Performing a DCF analysis typically involves these key steps:
- Project Free Cash Flows (FCF): Forecast the company's unlevered free cash flows for a specific period, usually 5 to 10 years. This involves making assumptions about revenue growth, operating expenses, capital expenditures, and working capital.
- Determine the Discount Rate (WACC): Calculate the company's Weighted Average Cost of Capital (WACC). This rate reflects the blended cost of all capital sources (debt and equity) weighted by their respective proportions in the company's capital structure.
- Calculate the Terminal Value (TV): Estimate the value of the business beyond the explicit forecast period. The two common methods are the Perpetuity Growth Model (Gordon Growth Model) or the Exit Multiple Method.
- Perpetuity Growth Model:
TV = [FCF at (n+1) * (1 + g)] / (r - g)wheregis the perpetual growth rate of FCF. - Exit Multiple Method:
TV = Last Forecasted Financial Metric (e.g., EBITDA) * Exit Multiple.
- Perpetuity Growth Model:
- Discount Future Cash Flows: Calculate the present value of each year's projected free cash flow and the terminal value using the discount rate determined in Step 2.
Present Value of CFt = CFt / (1 + r)^tPresent Value of TV = TV / (1 + r)^n
- Sum All Present Values: Add up the present values of all annual free cash flows and the present value of the terminal value. The sum represents the estimated intrinsic value of the company or asset.
Practical Insight
A DCF model provides an intrinsic valuation, meaning it estimates what an asset is worth based on its inherent characteristics, rather than relying on market comparisons. It's widely used in investment banking, corporate finance, and private equity to:
- Evaluate potential investments: Determine if an acquisition or project is financially viable.
- Assess company valuation: Price companies for mergers, acquisitions, or initial public offerings (IPOs).
- Make capital budgeting decisions: Decide whether to invest in long-term projects.
While powerful, DCF analysis is highly sensitive to the assumptions made, particularly regarding future cash flows, the discount rate, and the perpetual growth rate. Small changes in these assumptions can lead to significant variations in the estimated valuation.
