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Discounted cash flow (DCF) valuation is a type of financial model that determines whether an investment is worthwhile based on future cash flows. A DCF model is based on the idea that a company’s value is determined by how well the company can generate cash flows for its investors in the future.
In this guide, we’ll cover:
- What Is DCF Used For?
- How Do You Do a Discounted Cash Flow Valuation?
- How to Show DCF Skills on Your Resume
- Related Skills
- FAQ
What Is DCF Used For?
A discounted cash flow valuation is used to determine if an investment is worthwhile in the long run. For example, in investment banking, a DCF valuation is used to determine if a potential merger or acquisition is worth it. Additionally, DCF valuation is used in real estate and private equity.
Outside of corporate finance, DCF valuations can help business owners make budget decisions and determine their own projected value.
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How Do You Do a Discounted Cash Flow Valuation?
A core principle of finance is that $10 today is worth more than $10 a year from now. This principle is the “time value of money” concept, and it’s the foundation for DCF analysis. Projected future cash flows must be discounted to present value so they can be accurately analyzed.
What Is the DCF Valuation Formula?
There are three main parts to consider when doing a DCF valuation: the discount rate, the cash flows, and the number of periods. The formula for discounted cash flow is:
Where:
- CF₁ = Cash flow for the first period
- CF₂ = Cash flow for the second period
- CFₙ = Cash flow for “n” period
- n = Number of periods
- r = Discount rate
Components of the DCF Formula
Cash Flow (CF)
Cash flow is any sort of earnings or dividends. These cash flows can include revenues from the sales of products or services or cash from selling an asset.
Number of Periods (n)
The number of periods is however many years the cash flows are expected to occur. Oftentimes, the number of periods is 10, or 10 years, as this is the average lifespan of a company. However, depending on the company itself, this period could be longer or shorter.
Discount Rate (r)
The discount rate brings future costs to present value. Typically, the discount rate is the company’s cost of capital, or how much the company must make to justify the cost of operation. This cost is usually the weighted average cost of capital (WACC), which is the company’s interest rate and loan payments or dividend payments to shareholders.
DCF Valuation Example
Let’s say you have a company, and you want to start a big project. Your company’s weighted average cost of capital is 8%, so you’ll use 8% for your discount rate. The project is set to last for five years, and your company needs to put in an initial investment of $15 million. Cash flows for the project are:
- Year 1: $1 million
- Year 2: $2 million
- Year 3: $5 million
- Year 4: $5 million
- Year 5: $7 million
So, using these future cash flows and your 8% discount rate, your yearly discounted cash flows are:
| Year | Projected Cash Flow | Discounted Cash Flow* |
| 1 | $1,000,000 | $925,926 |
| 2 | $2,000,000 | $1,714,678 |
| 3 | $5,000,000 | $3,969,161 |
| 4 | $5,000,000 | $3,675,149 |
| 5 | $7,000,000 | $4,764,082 |
To determine if this project is a worthwhile investment, we need to compare the initial investment to the sum of the discounted cash flows over the lifetime of the project.
- Initial Investment: $15,000,000
- Discount cash flow sum: $15,048,996
- Net present value for project: $48,996
The net present value is found by subtracting the initial investment cost from the sum of the discounted cash flows. The net present value is a positive number, meaning that the money generated by the project is more than the initial investment. Ultimately, this project would be at least mildly profitable.
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How to Show DCF Skills on Your Resume
DCF valuation is a type of financial model used by many finance professionals. There are two key ways you can highlight DCF skills on your resume.
- Skills section: You can list “financial modeling” in your skills section. You can also include DCF specifically, and any other types of modeling you are skilled in, alongside financial modeling.
- Work or internship experience section: You can mention an instance where you created a DCF model as part of prior work or internship experience.
>>MORE: Learn if finance is a good career path.
DCF valuation is a core skill for many finance professionals, including investment bankers. Some other useful skills include:
- Calculating the weighted average cost of capital (WACC)
- Using Excel
- Completing a comparable company analysis
- Understanding debt capital markets
You can learn these skills (and more!) using Forage’s Investment Banking Career Path.
FAQ
Is DCF good for valuation?
Yes, DCF models can provide intrinsic values for businesses and assets. However, the model is based on assumptions and estimations, so it can never be truly accurate. A DCF model relies on how well the discount rate or weighted average cost of capital (WACC) is calculated, and this metric can be tricky to determine. Analysts should always use DCF models in conjunction with other approaches, such as comparable analysis and price-to-earnings (P/E) ratios.
Is DCF the same as NPV?
No, but they are closely related! Net present value (NPV) is often the final step in a discounted cash flow (DCF) analysis. You calculate an investment’s NPV by subtracting the initial investment from the sum of the investment’s discounted cash flows.
What is WACC for DCF valuation?
Weighted average cost of capital (WACC) is often used as the discount rate in a DCF model. WACC is the rate a company must pay (to lenders and shareholders) to justify operations. If the company brings in less money than this threshold, it can’t reliably sustain itself.
When would you not use a DCF for valuation?
DCF valuation is not a great tool for determining the value of banks and financial institutions. Rather than re-investing positive cash flows into the business, banks typically use those funds to create products. So, a DCF model can’t accurately predict future cash flows. Additionally, DCF models are unreliable for companies that keep much of their financial activity private. Without information about a company’s capital structure and investing activity, it is difficult to calculate WACC, making a DCF model less dependable.
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Written by
McKayla Girardin→
Writer
Read more from McKayla Girardin
McKayla Girardin is a NYC-based writer with Forage. She is experienced at transforming complex concepts into easily digestible articles to help anyone better understand the world we live in.
As someone deeply entrenched in the world of finance, particularly in the realm of valuation techniques like Discounted Cash Flow (DCF), I can attest to the critical role DCF plays in investment analysis and decision-making. Let's break down the key concepts presented in the article:
-
Discounted Cash Flow (DCF) Valuation:
- DCF valuation is a cornerstone financial model used to evaluate the attractiveness of an investment by estimating its future cash flows and discounting them to their present value.
- The premise is rooted in the time value of money principle, which states that a dollar today is worth more than a dollar in the future due to potential earning capacity.
- This valuation method is widely employed in various sectors including investment banking, real estate, and private equity to assess the viability of mergers, acquisitions, projects, or entire businesses.
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Components of DCF Formula:
- Cash Flow (CF): Represents the projected future earnings or dividends generated by the investment.
- Number of Periods (n): Signifies the duration over which cash flows are expected to materialize, often spanning multiple years.
- Discount Rate (r): Reflects the rate at which future cash flows are discounted to their present value, typically derived from the company's cost of capital, such as the weighted average cost of capital (WACC).
-
DCF Valuation Example:
- Illustrated by a hypothetical scenario where a company evaluates the profitability of a project by comparing its initial investment with the sum of discounted cash flows over the project's lifespan.
- The net present value (NPV), calculated by subtracting the initial investment from the sum of discounted cash flows, serves as a metric to determine project feasibility.
-
Applications and Skills Development:
- DCF valuation skills are highly valued in the finance industry, particularly among investment bankers and financial analysts.
- These skills can be showcased on resumes through sections dedicated to financial modeling expertise and through descriptions of relevant work or internship experiences involving DCF analysis.
- Additional skills such as calculating WACC, utilizing Excel, conducting comparable company analysis, and understanding debt capital markets complement DCF proficiency and contribute to comprehensive financial analysis.
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FAQs:
- Address common queries about the reliability and applicability of DCF valuation, emphasizing its utility alongside other valuation methods and its limitations in certain contexts such as banking and companies with opaque financial structures.
The article provides a comprehensive overview of DCF valuation, from its theoretical underpinnings to practical application, highlighting its significance in financial decision-making across various industries.
