DCF analysis made simple

by Admin
Updated: July 4, 2018

An introduction to Discounted Cash Flow (DCF) analysis made simple for evaluating investments

DCF is one of finance’s most useful tools and also one if its best kept secrets. Its power is hidden in plain view, concealed by confusing terminology and scary-looking equations. In this introduction I attempt to reveal the benefits of DCF without the jargon and (as much as I love mathematics) no equations at all.

DCF is short for “Discounted Cash Flow(s)” and is a way of valuing a business, investment or project based on how much cash it has in the future. It is an extension of normal cash flow analysis that takes into account the time value of money meaning cash in the future may not be worth what it is today.

What are these cash flows?

The “cash flows” in question refer to future values that are in the form of cash as opposed to less liquid assets.

Consider a business that has most of its value in the form of cash: This business will have arrived at this situation as a result of strong positive cash flow but, unlike cash flow projections, here it is only the end result,[1] not the process,[2] that we care about.

  1. DCF can also take account of income in perpetuity.
  2. It is always assumed that the project is sufficiently funded.

Why are they important?

A business that increases in value and has most of that value in the form of cash in the bank can be regarded as a better investment than the same business with most of its value in the form of other assets because cash can be distributed to the investors easily and without having to sell anything (without adversely affecting the operation of the business).

An investment that involves cash can only be regarded as good if it returns more cash in real terms.

Why are they discounted?

If you invest some money and get back the same amount later, you will have actually made a loss:

  1. Inflation means that money in the future will not buy as much as it does now.
  2. Money put into bonds or a savings account would have earned you some interest.
  3. You’ve not been compensated for the risk of not getting the money back.

The money that you get back from an investment/project in the future must be discounted by the factors that reduce its value during the time it’s locked-in: Time is money.

How are they discounted?

In principle it is essentially the same as the skeptical approach to compound interest where we calculate forward from present investment to future value

e.g. $1,000 invested returns $1,200

and discount it by the rate of inflation to reveal its present value

e.g. $1,200 only buys what $1,100 can buy now.

With DCF we try to take account of all the factors that diminish our return so we can evaluate our investment in terms of how much we’ll get back in today’s money, i.e. a present day value we can relate to.

Warnings

  • DCF is not a simple tool for analysis - the mathematics can get ridiculously complicated.
  • As the complexity of the calculations increases so does the difficulty in spotting errors.
  • The calculations are only as good as the assumptions used in them and DCF requires quite a lot of predicting the future.
  • DCF is a very useful tool for evaluating if a project is worth undertaking. It is much less useful for evaluating things like share prices because it takes no account of perceived value.

More info

A primer on Discounted Cash Flow at thestreet.com.

“Discounted Cash Flow Analysis: Complete Tutorial With Examples” at lynalden.com includes chart and math.

“Guide to the Discounted Cash Flow DCF Formula” at corporatefinanceinstitute.com includes video and math.

“DCF Model Training: 6 Steps to Building a DCF Model in Excel” at wallstreetprep.com includes math and spreadsheet downloads.

Internal links

Cash flow Compound interest and inflation Spreadsheets Go to Articles
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