Deep Dive into Discounted Cash Flow (DCF)
Preparing for an interview?
If you’re prepping for the upcoming investment banking recruiting cycle, it is almost guaranteed you will be asked about the ins and outs of a DCF model and its significance for both investors and companies. Knowing the importance and application of this valuation tool is crucial if you’re looking to break into an investment bank or virtually any finance-related field.
Let’s take a look…
What is Discounted Cash Flow?
Discounted cash flow (DCF) is a valuation method used by both companies and investors when determining the value of an investment.
The DCF aims to determine the value of an investment today by using the expected future cash flows the investment will generate.
The DCF is not only used for determining the value of securities and businesses, as this valuation tool can be used to determine business decisions and investments in capital.
The Functionality of a DCF
To break things into simpler terms, the DCF estimates the amount of cash an investor would receive from that investment, while adjusting for the time value of money.
Time value of money refers to the concept that a dollar today is worth more than a dollar tomorrow, due to your ability to invest it. Discounted cash flow comes into play by helping the investor determine the present value of expected future cash flows using the discount rate (generally the WACC).
The WACC is generally used as the discount rate as it represents the required rate of return investors expect from investing in that company.
If the future projected cash flows are greater than the value of the initial investment, the investment is worth considering. On the other hand, if the projected value is lower, the investment might require further analysis.
The DCF is only as good as the assumptions you use. With poor assumptions in the WACC and future cash flows, you can get an output that can displays alarming figures.
The Golden Rule: if you put in trash, you’ll get out trash
Discounted Cash Flow Formula
Pros and Cons of DCF
Advantages:
Helps investors determine whether an investment will generate more cash than the initial investment
Wide variety of applications
Can be used with different assumptions - commonly within investment banking this is seen with “Best Case”, “Base Case”, and “Weak Case”
Disadvantages:
This formula is an estimate and figures may not be accurate when put into practice
This formula doesn’t take external factors into account, such as legislation, market conditions, competition, demand, etc…
Investors shouldn’t solely rely on the DCF, as there are many other factors to consider. Using comparable company analysis and prior transactions are crucial in order to help solidify your decision
Net Present Value (NPV) vs Discounted Cash Flow (DCF)
Net present value and discounted cash flow are commonly misinterpreted as the same thing, when this simply is not the case. Net present value take one additional step in the process and takes the discounted cash flows and subtracts the initial cost of the investment.
Net Present Value = DCF - Initial Cost of Investment
Key Takeaways
Calculating the DCF takes three steps: forecast expected cash flows of the investment, choose the discount rate (typically WACC), then discount the projected cash flows back to present day
The DCF helps investors determine the value of an investment based on its future cash flows
Present value of the investment is used by using the discount rate
If DCF > current cost of investment, then the investment is worth considering
The DCF shouldn’t be solely relied upon for valuation, as there are many other factors to consider (use comparable companies analysis, and prior transactions, etc…)
