What Is a Discounted Cash Flow Model? | DCF Formula

By Kirsteen Mackay

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The discounted cash flow formula and model is used by analysts to find a company's fair value share price. Read on for an overview of the DCF model and its inputs.

discounted cash flow (DCF) model

A discounted cash flow (DCF) model is a method used to evaluate the intrinsic value of an investment. It is a financial model that calculates the present value of expected future cash flows from an investment, taking into account the time value of money and the appropriate discount rate.

By comparing this present value to the current price of the investment, the DCF model can help investors determine whether the investment is undervalued or overvalued.

What is the Discounted Cash Flow Formula?

The discounted cash flow (DCF) formula is as follows:

DCF = CF1 / (1 + r)^1 + CF2 / (1 + r)^2 + CF3 / (1 + r)^3 + ... + CFn / (1 + r)^n

In this formula, CF1, CF2, CF3, ..., CFn represent the expected cash flows from the investment at different points in time, and r is the appropriate discount rate to use in the calculation. The exponent in the formula indicates the number of periods (typically years) between the present and the time at which the corresponding cash flow is expected to occur.

To use the DCF formula, you will need to forecast the expected cash flows from the investment and determine the appropriate discount rate to use in the calculation. You will then input these values into the formula to calculate the present value of the investment's future cash flows. This present value can be compared to the investment's current price to determine whether it is undervalued or overvalued.

What data inputs do I need to create a DCF model?

To create a DCF model, you will need several pieces of data, including:

  1. The expected cash flows from the investment over a specific period. These cash flows should be based on realistic and well-researched assumptions about the future performance of the investment.

  2. The appropriate discount rate to use in the model. This rate should reflect the expected rate of return that investors would require to compensate them for the level of risk associated with the investment.

  3. The expected terminal value of the investment at the end of the period. This is the estimated value of the investment beyond the period covered by the cash flow projections.

  4. Any additional information or assumptions that may be relevant to the calculation, such as the expected growth rate of the investment or the tax rate applicable to the investment's cash flows.

Once you have collected this data, you can use a DCF model to calculate the present value of the expected future cash flows and compare it to the investment's current price. This will help you determine whether the investment is undervalued or overvalued.

How do I calculate the expected cash flows?

To calculate the expected cash flows from an investment, you will need to make assumptions about the future performance of the investment. These assumptions can help forecast the cash flows that the investment is likely to generate.

This can be a complex and challenging task, as it requires you to have a good understanding of the investment and the factors that will affect its future performance.

Here are some steps that you can follow to calculate the expected cash flows from an investment:

  1. Identify the key drivers of the investment's performance. These may include factors such as market demand for the investment's product or service, the competitive environment in which the investment operates, and the investment's cost structure and pricing strategy.

  2. Develop realistic and well-researched assumptions about how these drivers will evolve. This may involve conducting market research, analyzing industry trends, and consulting with experts or other stakeholders.

  3. Use these assumptions to forecast the investment's future cash flows. This may involve creating detailed financial projections that consider the investment's expected revenues, expenses, and other cash flows.

  4. Review and refine your assumptions and projections as necessary. As you work on your cash flow projections, you may need to adjust your assumptions and make changes to your model to reflect new information or changing circumstances. 

It is important to remember that the accuracy of your DCF model will depend heavily on the quality of your assumptions and projections. As such, it is crucial to research and analyze the investment and its potential future performance before you begin working on your DCF analysis.

How do I calculate the appropriate discount rate to use in a DCF model?

The appropriate discount rate to use in a DCF model is the rate of return that investors would require to compensate them for the level of risk associated with the investment. This rate reflects the trade-off between the time value of money and the level of risk that investors are willing to take on. 

To calculate the appropriate discount rate for a DCF model, you will need to consider several factors, including:

  1. The expected rate of return on a risk-free investment, such as a government bond. This rate represents the minimum level of return that investors would require to compensate them for the time value of money.

  2. The expected volatility and risk of the investment being evaluated. The higher the level of risk associated with the investment, the higher the rate of return that investors would require to compensate them for taking on that risk.

  3. The expected returns of similar investments. By comparing the expected returns of similar investments, you can determine the rate of return that investors would require to compensate them for the level of risk associated with the investment being evaluated.

Once you have considered these factors, you can use them to calculate the appropriate discount rate to use in your DCF model. This rate should reflect the expected rate of return that investors would require to compensate them for the level of risk associated with the investment. 

It is important to remember that the appropriate discount rate can vary depending on the specific investment being evaluated and the circumstances of the investment. As such, your valuation method should carefully consider the relevant factors and adjust the discount rate as needed to ensure that it accurately reflects the expected returns of the investment.

What is the expected terminal value, and how do I calculate it?

The expected terminal value is the estimated value of an investment beyond the period covered by the cash flow projections in a DCF model. It is calculated by assuming that the investment will continue to grow at a constant rate into the future, and it is typically used to account for the long-term value of the investment.

To calculate the expected terminal value of an investment, you will need to make assumptions about the future growth rate of the investment and the length of time over which the investment is expected to continue growing. You will also need to consider the appropriate discount rate to use in the calculation.

Here are the steps you can follow to calculate the expected terminal value of an investment:

  1. Determine the expected growth rate of the investment. This should be a realistic and well-researched assumption based on the expected future performance of the investment and the factors that are likely to affect its growth.

  2. Identify the length of time over which the investment is expected to continue growing at the assumed growth rate. This is the period beyond the end of the cash flow projections in the DCF model.

  3. Calculate the expected terminal value using the following formula:

    Terminal value = (Cash flows from the investment at the end of the period covered by the cash flow projections) * (1 + expected growth rate) / (discount rate - expected growth rate)

  4. Adjust the expected terminal value as needed to reflect any additional information or assumptions that may be relevant to the calculation.

It is important to remember that the expected terminal value is a highly sensitive assumption in a DCF model, as it can significantly impact the overall value of the investment. As such, it is crucial to make realistic and well-researched assumptions about the investment's future growth and carefully consider the appropriate discount rate to use in the calculation.

How long does it take to create a discounted cash flow model for a company?

The amount of time it takes to create a discounted cash flow (DCF) model for a company can vary depending on several factors. For instance, the complexity of the company's operations, the availability of data and information, and the level of expertise of the person creating the model. 

Creating a DCF model for a company is a complex and time-consuming task requiring careful research and analysis. It may take several days or even weeks to gather the necessary data and perform the calculations needed to develop a comprehensive and accurate DCF model for a company. 

In addition to the initial development of the model, it is important to note that DCF models are dynamic and may need to be updated regularly as new information becomes available or the company's circumstances change. This can require additional time and effort on an ongoing basis.

Overall, creating a DCF model for a company is a significant undertaking that requires careful planning and a considerable investment of time and resources.

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Topics:
Investing
Value Investing
Industries:
Financials

Author: Kirsteen Mackay

This article does not provide any financial advice and is not a recommendation to deal in any securities or product. Investments may fall in value and an investor may lose some or all of their investment. Past performance is not an indicator of future performance.

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