What is a discounted cash flow?
A discounted cash flow is a valuation method used to estimate the future value of a company based on the company’s present performance.
In brief, it tells you how much money a company can generate in the future with the present cash by determining its intrinsic value.
Discounted cash flow and its components
Discounted cash flow comprises the three components to forecast the future value of a company. These are:-
- The current free cash flow of a company
- Future value of a company
- The expected growth rate of a company
To conclude, if we get the value of these three components, then we can calculate the intrinsic value of a company by the help of the discounted cash flow method.
1. Cash Flow of a company
In the first place, the free cash flow of a company is the net cash and cash equivalents left to the company after deducting the operating expenses and capital expenditures from the earning through its core operation.
In terms of a formula, it can define as:
Free cash flow = Cash from operating activity – Capital expenditures.
2. Future value
Definitely, the purpose of DCF is to get the expected future value of a company by assuming the estimated interest rate for a defined period.
In terms of a formula, it can define as:
Future value = Present value * (1+ R) ^ time.
“^” = Exponent to take a no. to a power
“Time” = No. of years.
“R” = Annual interest rate
In other words, it implies the relation of future value and present value. However, the result highly depends on the estimated annual interest rate.
» How to find the Future value
Although, the future value of a company has the defined formula to get the values. It can find by using two popular methods. These are:
- Financial calculator. For eg:- HP 12c.
- Microsoft Excel sheet.
1. Financial Calculator
It is an electronic device used to perform complex calculations with faster speed. For example – the complex calculations which are involved in routine business operations such as compound interest, margin, present value, etc. can be done in a fraction of seconds.
Moreover, it comes with hotkeys to complete the lengthy calculations in one press.
Lastly, the financial calculator’s capability to complete the calculation in a fraction of a second makes it a popular device.
› How to calculate the “Future Value” using HP-12 C financial calculator
Unlike a general-purpose calculator, the operation of the financial calculator is different and requires more skill to operate.
Yet, the following steps in HP-12C can use to calculate the present value :
Press to clear the financial registers.
Enter the number of payments or periods, using or .
Enter the periodic interest rate, using or
Press to calculate future value.
Besides, its portability allows the user to carry out the calculations anywhere in a fraction of seconds.
2. Microsoft Excel
Equally important, the second method to carry out the complex calculations is Microsoft Excel, it is easy to use and doesn’t need any extra cost and expertise to operate.
In reality, a user who knows well to work in an excel spreadsheet can calculate the future value by inserting the rate of interest, no of periods and required values in the defined formula.
Type “= FV(rate of interest, no. of periods, several interim payments(generally 0), Present value)”.
Let’s illustrate with an example.
Mr X wants to know the future value of the 100K after 5 years by assuming the Interest rate of 5% with zero interim payments.
All things considered, insert the values in the spreadsheet under the defined format
Hence, the answer will come as a 1,27,628/-
3. Growth Rate
While the growth rate tells an investor how efficiently the company is performing with the available resources. Besides, one can see the past performance of the company.
Although, the future growth requires an assumption based on either of two sources. These are:-
- Historical Trend Analysis
- Expert analyst’s prediction
1. Historical trend analysis
For the purpose of predicting the future growth rate, the historical growth rate is considered. Altogether, it is assumed that the future growth rate will follow the historical trend.
» What are the advantages of the historical trend analysis method?
- For the most part, the past data is easily available and requires limited efforts to calculate future growth rate
- In general, no expertise requires in predicting the future growth as it is entirely depending on the past data
- Consequently, the result cannot change person to person as the process remains same to predict the future growth
» What are the disadvantages of the historical trend analysis method?
- In any event, it cannot consider the change in future’s economic conditions which makes it less reliable.
- In the long run, the company may deteriorate but the future growth expectation is high because of past data
2. Expert analyst’s prediction
On the whole, the economist visualizes future growth with the help of proven methods and tools.
Above all, an investor can believe in the analyst’s prediction because of their expertise and in-depth knowledge of various economic factors.
» What are the advantages of the expert analyst’s prediction?
- In the final analysis, it considers the change in future’s economic conditions, which makes it more reliable.
- In essence, it gives the high weightage to the company’s current growth rate that predicts the future growth rate of a company with respect to economic condition,
» What are the disadvantages of the expert analyst’s prediction?
- For the most part, it requires expertise in predicting future growth, as it requires in-depth -knowledge of the subject.
- By and large, the result can vary from person to person as the tools and methods differ.
How to calculate the discounted cash flow?
In the first place, we find the current free cash flow of a company, the present value of a company and the expected growth rate.
Finally, the discounted cash flow utilised these three values to give the intrinsic value of a company.
Thus, the discounted cash flow can find by using the step-by-step guide to find the intrinsic value of the company.
By using the free cash flow formula, the first step is to find the cash flow of a company for the number of years.
Free cash flow = Cash from operating activity – Capital expenditures
Let’s assume the free cash flow of the company in a current year is INR 772.2 crore and the future growth rate of 10% for the next 5 years.
For this reason, multiply the previous year’s cash flow by 10%, or simply by 1.1 to get the value of next year
The figures in the table show cash flow from 2019 to 2023.
Expected Free cash flow in future (in Cr.)
Afterwards, the next step is to find the future value of expected free cash flow find in Step I by using the below formula
Future value = Present value * (1+interest rate) ^ time
Altogether, we assumed the Interest rate of 6% for term 5 years. As a result, we can find the discounted cash flow for the defined term.
Hence, it can give us the intrinsic value of a company which defines whether the company is overvalued or undervalued.
To conclude, if the discounted cash flow value is greater than the current market cap, then the stock is undervalued else it is overvalued.
Discounted cash flow is one of the best technique to find the intrinsic value of a stock. However, it can give the best results when combines with other valuation tools.
By and large, the DCF has limitations that it relies on estimations of future cash flows which may prove wrong.
Regardless of some limitations, DCF is considered as one of the best valuation methods to determine the value of a company in the long run.