Discounted cash flow

The discounted cash flow (DCF) analysis, in finance, is a method used to value a security, project,
company, or asset, that incorporates the time value of money. Discounted cash flow analysis is widely used
in investment finance, real estate development, corporate financial management, and patent valuation. Used
in industry as early as the 1700s or 1800s, it was widely discussed in financial economics in the 1960s, and
U.S. courts began employing the concept in the 1980s and 1990s.

Application
In discount cash flow analysis, all future cash flows are estimated Main Elements
and discounted by using cost of capital to give their present values
(PVs). The sum of all future cash flows, both incoming and On a very high level, the main
outgoing, is the net present value (NPV), which is taken as the elements in valuing a corporate
value of the cash flows in question;[2] see aside. by Discounted Cash Flow are as
follows; see Valuation using
For further context see Valuation (finance) § Valuation overview; discounted cash flows, and
and for the mechanics see valuation using discounted cash flows, graphics below, for detail:
which includes modifications typical for startups, private equity
and venture capital, corporate finance "projects", and mergers and Free Cash Flow Projections:
acquisitions. Projections of the amount of Cash
produced by a company's business
operations after paying for operating
Using DCF analysis to compute the NPV takes as input cash expenses and capital
flows and a discount rate and gives as output a present value. The expenditures.[1]
opposite process takes cash flows and a price (present value) as Discount Rate: The cost of capital
inputs, and provides as output the discount rate; this is used in (Debt and Equity) for the business.
bond markets to obtain the yield. This rate, which acts like an interest
rate on future Cash inflows, is used
to convert them into current dollar
History equivalents.
Terminal Value: The value of a
business at the end of the
Discounted cash flow calculations have been used in some form projection period (typical for a DCF
since money was first lent at interest in ancient times. Studies of analysis is either a 5-year projection
period or, occasionally, a 10-year
ancient Egyptian and Babylonian mathematics suggest that they projection period).[1]
used techniques similar to discounting future cash flows. Modern
discounted cash flow analysis has been used since at least the early
1700s in the UK coal industry.[3]
Discounted cash flow valuation is differentiated from the
accounting book value, which is based on the amount paid for the
asset.[4] 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.[5]

Mathematics

Discounted cash flows

The discounted cash flow formula is derived from the present value
formula for calculating the time value of money
Flowchart for a typical DCF
valuation, with each step detailed in
the text (click on image to see at full
size)
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 Here, a spreadsheet valuation, uses
flow (FV), or FV adjusted for the delay in receipt;
Free cash flows to estimate stock's
FV is the nominal value of a cash flow amount in a future Fair Value and measure the
period (see Mid-year adjustment); sensitivity of WACC and Perpetual
r is the interest rate or discount rate, which reflects the growth
cost of tying up capital and may also allow for the risk
that the payment may not be received in full;[6]
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 r, 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 the Terminal 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 .

Discount rate
The act of discounting future cash flows asks "how much money would have to be invested currently, at a
given rate of return, to yield the forecast cash flow, at its future date?" In other words, discounting returns
the present value of future cash flows, where the rate used is the cost of capital that appropriately reflects
the risk, and timing, of the cash flows.

This "required return" thus incorporates:

1. Time value of money (risk-free rate) – according to the theory of time 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.

For the latter, various models have been developed, where the premium is (typically) calculated as a
function of the asset's performance with reference to some macroeconomic variable - for example, the
CAPM compares the asset's historical returns to the "overall market's"; see Capital asset pricing model
§ Asset-specific required return and Asset pricing § General equilibrium asset pricing.

An alternate, although less common approach, is to apply a "fundamental valuation" method, such as the
"T-model", which instead relies on accounting information. (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. In this context the above is referred to as "exponential discounting".)

The terminology "expected return", although formally the mathematical expected value, is often used
interchangeably with the above, where "expected" means "required" or "demanded" by investors.

The method may also be modified by industry, for example various formulae have been proposed when
choosing a discount rate in a healthcare setting;[7] similarly in a mining setting, where risk-characteristics
can differ (dramatically) by property. [8]

Methods of appraisal of a company or project

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.) The below is offered as a high-level treatment; for the components / steps of
business modeling here, see Outline of finance § Financial modeling.

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.
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.[9]

Shortcomings
The following difficulties are identified with the application of DCF in valuation:

1. Forecast reliability: Traditional DCF models assume we can accurately forecast revenue
and earnings 3–5 years into the future. But studies have shown that growth is neither
predictable nor persistent.[10] (See Stock valuation#Growth rate and Sustainable growth
rate#From a financial perspective.)
 In other terms, using DCF models is problematic due to the problem of induction, i.e.
presupposing that a sequence of events in the future will occur as it always has in the past.
Colloquially, in the world of finance, the problem of induction is often simplified with the
common phrase: past returns are not indicative of future results. In fact, the SEC demands
that all mutual funds use this sentence to warn their investors.[11]
This observation has led some to conclude that DCF models should only be used to value
companies with steady cash flows. For example, DCF models are widely used to value
mature companies in stable industry sectors, such as utilities. For industries that are
especially unpredictable and thus harder to forecast, DCF models can prove especially
challenging. Industry Examples:
Real Estate: Investors use DCF models to value commercial real estate development
projects. This practice has two main shortcomings. First, the discount rate assumption
relies on the market for competing investments at the time of the analysis, which may not
persist into the future. Second, assumptions about ten-year income increases are usually
based on historic increases in the market rent. Yet the cyclical nature of most real estate
markets is not factored in. Most real estate loans are made during boom real estate
markets and these markets usually last fewer than ten years. In this case, due to the
problem of induction, using a DCF model to value commercial real estate during any but
the early years of a boom market can lead to overvaluation.[12]
Early-stage Technology Companies: In valuing startups, the DCF method can be applied
a number of times, with differing assumptions, to assess a range of possible future
outcomes—such as the best, worst and mostly likely case scenarios. Even so, the lack of
historical company data and uncertainty about factors that can affect the company's
development make DCF models especially difficult for valuing startups. There is a lack
of credibility regarding future cash flows, future cost of capital, and the company's growth
rate. By forecasting limited data into an unpredictable future, the problem of induction is
especially pronounced.[13]
2. Discount rate estimation: Traditionally, DCF models assume that the capital asset pricing
model can be used to assess the riskiness of an investment and set an appropriate discount
rate. Some economists, however, suggest that the capital asset pricing model has been
empirically invalidated.[14] various other models are proposed (see asset pricing), although
all are subject to some theoretical or empirical criticism.
3. Input-output problem: 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. This is especially the case with terminal values, which
make up a large proportion of the Discounted Cash Flow's final value.
4. Missing variables: Traditional DCF calculations only consider the financial costs and
benefits of a decision. They do not include the environmental, social and governance
performance of an organization.[15] This criticism, true for all valuation techniques, is
addressed through an approach called "IntFV" discussed below.

Integrated future value

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 (IntFV).[16]

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 to identify new areas for value creation that
are not revealed through traditional financial reporting. As an example, the social cost of carbon is one
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. [17]

See also
Adjusted present value
Capital asset pricing model
Capital budgeting
Cost of capital
Debt ratio
Economic value added
Enterprise value
Financial reporting
Flows to equity
Forecast period (finance)
Free cash flow
Internal rate of return
Market value added
Net present value
Owner earnings
Patent valuation
Present value of growth opportunities
Residual income valuation
Terminal value (finance)
Time value of money
Valuation using discounted cash flows
Weighted average cost of capital

References
1. "Discounted Cash Flow Analysis | Street of Walls" (http://www.streetofwalls.com/finance-trai
ning-courses/investment-banking-technical-training/discounted-cash-flow-analysis/).
streetofwalls.com. Retrieved 7 October 2019.
2. "Wall Street Oasis (DCF)" (http://www.wallstreetoasis.com/finance-dictionary/what-is-a-disco
unted-cash-flow-DCF). Wall Street Oasis. Retrieved 5 February 2015.
3. Susie Brackenborough, et al., The Emergence of Discounted Cash Flow Analysis in the
Tyneside Coal Industry c.1700-1820. The British Accounting Review 33(2):137-155
DOI:10.1006/bare.2001.0158
4. Otto Eduard Neugebauer, The Exact Sciences in Antiquity (Copenhagen :Ejnar Mukaguard,
1951) p. 33 (1969). Otto Eduard Neugebauer, The Exact Sciences in Antiquity (Copenhagen
:Ejnar Mukaguard, 1951) p. 33. US: Dover Publications. p. 33. ISBN 978-0-486-22332-2.
5. Fisher, Irving. "The theory of interest." New York 43 (1930).
 6. "Discount rates and net present value" (https://web.archive.org/web/20140304094708/http://
data.gov.uk/sib_knowledge_box/discount-rates-and-net-present-value). Centre for Social
Impact Bonds. Archived from the original (http://data.gov.uk/sib_knowledge_box/discount-rat
es-and-net-present-value) on 4 March 2014. Retrieved 28 February 2014.
7. Lim, Andy; Lim, Alvin (2019). "Choosing the discount rate in an economic analysis".
Emergency Medicine Australasia. 31 (5): 898–899. doi:10.1111/1742-6723.13357 (https://do
i.org/10.1111%2F1742-6723.13357). ISSN 1742-6723 (https://www.worldcat.org/issn/1742-
6723). PMID 31342660 (https://pubmed.ncbi.nlm.nih.gov/31342660). S2CID 198495952 (htt
ps://api.semanticscholar.org/CorpusID:198495952).
8. Queen's University minewiki (N.D.). "Discount rate" (https://minewiki.engineering.queensu.c
a/mediawiki/index.php/Discount_rate)
9. Pratt, Shannon; Robert F. Reilly; Robert P. Schweihs (2000). Valuing a Business (https://boo
ks.google.com/books?id=WO6wd8O8dsUC&q=shannon+pratt). McGraw-Hill Professional.
McGraw Hill. ISBN 0-07-135615-0.
10. Chan, Louis K.C.; Karceski, Jason; Lakonishok, Josef (May 2001). "The Level and
Persistence of Growth Rates" (https://doi.org/10.3386%2Fw8282). Cambridge, MA.
doi:10.3386/w8282 (https://doi.org/10.3386%2Fw8282).
11. "SEC.gov | Mutual Funds, Past Performance" (https://www.sec.gov/fast-answers/answersmp
erfhtm.html). sec.gov. Retrieved 8 May 2019.
12. Reilly, Robert F.; Schweihs, Robert P. (28 October 2016). Guide to Intangible Asset
Valuation. doi:10.1002/9781119448402 (https://doi.org/10.1002%2F9781119448402).
ISBN 9781119448402. S2CID 168737069 (https://api.semanticscholar.org/CorpusID:16873
7069).
13. "Measuring and Managing Value in High-Tech Start-ups", Valuation for M&A, John Wiley &
Sons, Inc., 12 September 2015, pp. 285–311, doi:10.1002/9781119200154.ch18 (https://doi.
org/10.1002%2F9781119200154.ch18), ISBN 9781119200154
14. Fama, Eugene F.; French, Kenneth R. (2003). "The Capital Asset Pricing Model: Theory and
Evidence". SSRN Working Paper Series. doi:10.2139/ssrn.440920 (https://doi.org/10.2139%
2Fssrn.440920). ISSN 1556-5068 (https://www.worldcat.org/issn/1556-5068).
S2CID 12059689 (https://api.semanticscholar.org/CorpusID:12059689).
15. Sroufe, Robert, author. (5 October 2018). Integrated management : how sustainability
creates value for any business. ISBN 978-1787145627. OCLC 1059620526 (https://www.wo
rldcat.org/oclc/1059620526). {{cite book}}: |last= has generic name (help)
16. Eccles, Robert; Krzus, Michael (2010). One Report: Integrated Reporting for a Sustainable
Strategy (https://archive.org/details/onereportintegra00eccl_0). Wiley.
ISBN 9780470587515.
17. Sroufe, Robert (July 2017). "Integration and Organizational Change Towards Sustainability"
(https://www.researchgate.net/publication/318126290). Journal of Cleaner Production. 162:
315–329. doi:10.1016/j.jclepro.2017.05.180 (https://doi.org/10.1016%2Fj.jclepro.2017.05.18
0) – via Research Gate.

Further reading
International Federation of Accountants (2008). Project Appraisal Using Discounted Cash
Flow (https://www.ifac.org/system/files/publications/files/Project-Appraisal-Using-DCF.pdf)
(PDF). Archived (https://web.archive.org/web/20190414093226/https://www.ifac.org/system/f
iles/publications/files/Project-Appraisal-Using-DCF.pdf) (PDF) from the original on 14 April
2019.
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 978-0-470-
44220-3.
James R. Hitchnera (2006). Financial Valuation: Applications and Models. Wiley Finance.
ISBN 0-471-76117-6.
Chander Sawhney (2012). Discounted Cash Flow – The Prominent Income Approach to
Valuation (http://corporatevaluations.in/static-1047-22-oth%20-Articles%20and%20Researc
h%20Hub). corporatevaluations.in.

External links
Calculating Intrinsic Value Using the DCF Model (https://wealthyeducation.com/how-to-calc
ulate-intrinsic-value/), wealthyeducation.com
Calculating Terminal Value Using the DCF Model (https://wealthyeducation.com/how-to-calc
ulate-terminal-value/), wealthyeducation.com
Continuous compounding/cash flows (http://ocw.mit.edu/courses/nuclear-engineering/22-81
2j-managing-nuclear-technology-spring-2004/lecture-notes/lec03slides.pdf), ocw.mit.edu
Getting Started With Discounted Cash Flows (https://web.archive.org/web/2008011011551
3/http://www.thestreet.com/university/personalfinance/10385275.html). The Street.

Retrieved from "https://en.wikipedia.org/w/index.php?title=Discounted_cash_flow&oldid=1165957879"