New projects and investments are assessed based on their ability to generate a return in the future. The value of an investment done in 2021 will be assessed based on its return in 2025. Well, in a utopian scenario, you would expect your investment to generate substantial returns in absolute terms.
However, that is not always the case. An investment of Rs. 1,00,000 done in 2021, can bring a return of Rs.40,000 in 2025. But that does not mean that your take-home profit is Rs.40,000. The real return is assessed by the changes in the value of money in 2025 vis à vis 2021.
These changes are represented and figured out with the help of cash discount flow and its related concepts.
What is Discounted Cash Flow?
Accountants use the concept of the time value of money to determine the value of Rs. 1 in 2021 and 2025. As a general principle, the value of Rs. 1 won’t be the same today as it will be in 2025.
Accordingly, the final value of returns in the investment needs to address the weightage given to the future costs and benefits. In other words, discounted cash flow or DCF is used to estimate the final value of the money invested in a project.
DCF may be a concept related to the future, but it assesses the value of an investment today. Working with the DCF concept, you can predict the profit a particular investment will generate.
Companies, stockbrokers, investors, etc., adopt this concept before making an investment or acquiring a company. As a result, if the discounted cash flow value is more than the initial investment, it means a positive return.
Discounted Cash Flow Formula
The formula for calculating DCF is (CF/(1+r)^1) + (CF/(1+r)^2) + (CF/(1+r)^n)
DCF = Discounted Cash Flow
CF = Cash Flow or the amount of money invested in the stock, project, etc.
r = The interest rate or the discounted rate.
n = period number or the number of years counted consecutively.
The discount rate or the interest rate applied to future costs and value of money is derived by the company’s accountants or other stakeholders involved in the transaction. To find out this rate, the accountants consider several discount factors like long term returns, cash shortfalls, etc. and arrive at a certain percentage that they believe reflects the true value of the money returned in the future. The inclusion of discount factors depends on the circumstances leading to the discount rate identification.
What can DCF tell you about your business?
By working out the DCF related to an investment plan, you can find out the closest intrinsic value of an asset or a business. While working with the DCF method, which considers Free Cash Flows or FCF as one of the methods of calculation, we can bypass the subjective policies considered in accounting.
Besides understanding the value of an asset down the line, investors can initiate changes in the business strategy or investment portfolio according to the outcomes. As they take several assumptions of discounted cash flow into account, they are well-positioned to initiate a change according to the requirements.
Lastly, you can use the DCF analysis to run a sanity check. The current share prices of the company can be inserted into the model along with the investment plans to find out whether the stocks are overvalued or undervalued.
How do you calculate Discounted Cash Flow?
The DCF is calculated based on the initial investment, the discounted rate, and the period in question. To calculate the DCF, you first need to list down the initial investment and the potential additional investment value that will be added to the asset.
Once you have the investment values and their expected returns, you need to find the discount rate and, with it, the discount factor. The discount factor represents the time value of money corresponding to the period.
By multiplying the cash flows with the discount factor, you will get the return of your investment according to the value of money in the future.
Discounted Cash Flow Example
To better understand the concept, let’s look at a discounted cash flow example:
|Calculating DCF||Year 0 (Current year)||Year 1 (One year from now)||Year 2 (Two years from now)||Year 3||Year 4|
From the table above, it is easy to determine that the investor is gaining in absolute terms. By making an initial investment of Rs.100,000, the investor is further adding Rs.10,000 to the asset every year and getting incremental returns.
The total profit after four years is Rs.10,000 after subtracting the investment (Rs.1,40,000) from returns (Rs.1,50,000).
But Rs.1 won’t have the same value four years down the line. So, we need to discount the change in that value to find out the real return.
Accordingly, we have set the discounted rate of 6% to find out the value of Rs.1 today corresponding to its value four years ahead. Applying the DCF formula, the discounted value for each year comes out to be:
- 0.943 for year 1
- 0.890 for year 2
- 0.840 for year 3
- 0.792 for year 4
This means that if you are to get Rs.1000 in profit at the end of the fourth year, its value today will be reduced to Rs.792.
|Calculating DCF||Year 0 (current year)||Year 1 (one year from now)||Year 2 (Two years from now)||Year 3||Year 4|
|Net Cash Flow||– Rs.100,000||+ Rs.15,000||+ Rs.25,000||+ Rs.35,000||+ Rs.35,000|
|Discounted Net Cash Flow||– Rs.100,000||Rs.14,145||Rs.22,250||Rs.29,400||Rs.27,720|
It can be observed from the table that the positive return of Rs.35,000 at the end of year four is not Rs.35,000. Instead, your take-home profit is Rs.27,720 for year four.
Is Discounted Cash Flow the same as Net Present Value?
No, they are not the same. The discounted cash flow is a component of net present value. We calculate the DCF to find out the projected cash flow from an investment. On the other hand, the net present value uses the DCF value to find out whether the said investment is profitable or not. A positive NPV means a good investment, and a negative NPV can form the basis for loss of money.
Limitations to DCF
One of the limitations of using this method is that any investor cannot precisely estimate the incoming cash flow of the future. In the example above, too, we have taken the incremental return in the cash flows as an assumption.
Because the future return is subject to several factors, we cannot pin a specific value to it, especially four years before it has actually happened.
Investing in stock, assets, or businesses requires understanding the future returns from the same. With accountants using several methods to determine returns, discounted cash flow is one of those methods.
This method finds out the value of projected cash flow or returns from an investment or project in terms of the present value of money. So, the next time you are about to make an investment or buy a stock, make sure to find out its DCF and NPV to find out whether the investment opportunity is any good or not.
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