How to Calculate Discounted Cash Flow

Discounted Cash Flow (DCF) Calculator

Calculation Results:

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Understanding the Discounted Cash Flow (DCF) Method

The Discounted Cash Flow (DCF) method is a valuation technique used to estimate the attractiveness of an investment opportunity. DCF analysis uses future free cash flow projections and discounts them to arrive at a present value estimate, which is used to evaluate the potential for investment. If the DCF value is higher than the current cost of the investment, the opportunity could be considered attractive.

How DCF Works

At its core, DCF is based on the principle that an asset's value is the sum of its future cash flows, discounted back to the present. This is because a dollar today is worth more than a dollar tomorrow due to factors like inflation and the opportunity cost of capital.

The DCF calculation typically involves two main phases:

1. Explicit Forecast Period: Projecting the company's Free Cash Flow (FCF) for a specific number of years (e.g., 5-10 years) where growth can be estimated with reasonable certainty.
2. Terminal Value Period: Estimating the value of all cash flows beyond the explicit forecast period, assuming a stable, perpetual growth rate.

Key Components of the DCF Calculator:

• Current Year Free Cash Flow (FCF): This is the starting point for your projections. FCF represents the cash a company generates after accounting for cash outflows to support operations and maintain its capital assets. It's the cash available to all capital providers (debt and equity).
• FCF Growth Rate (Explicit Period, %): This is the annual rate at which you expect the company's free cash flow to grow during the explicit forecast period. This rate should reflect the company's historical performance, industry trends, and future prospects.
• Number of Explicit Forecast Years: This defines the length of your detailed projection period. Common periods range from 5 to 10 years.
• Terminal Growth Rate (Perpetual, %): After the explicit forecast period, it's assumed the company will grow at a constant, sustainable rate indefinitely. This rate is typically low, often around the long-term inflation rate or GDP growth rate, as companies cannot grow at high rates forever.
• Discount Rate (WACC, %): The discount rate is crucial as it reflects the riskiness of the investment and the opportunity cost of capital. For a company, this is often represented by the Weighted Average Cost of Capital (WACC), which is the average rate of return a company expects to pay to finance its assets. A higher discount rate implies higher risk or higher opportunity cost, leading to a lower present value.

The Calculation Process:

1. Project Future FCFs: Starting with the Current Year FCF, project the FCF for each year of the explicit forecast period using the FCF Growth Rate.
2. Discount Explicit FCFs: Calculate the Present Value (PV) of each year's projected FCF by dividing it by (1 + Discount Rate) raised to the power of the year number. Sum these present values.
3. Calculate Terminal Value (TV): Using the Gordon Growth Model, the Terminal Value is calculated at the end of the explicit forecast period. The formula is: TV = (FCF_Year_N+1) / (Discount Rate - Terminal Growth Rate), where FCF_Year_N+1 is the FCF in the first year beyond the explicit forecast period.
4. Discount Terminal Value: Calculate the Present Value of the Terminal Value by discounting it back to the present day using the Discount Rate and the number of explicit forecast years.
5. Sum for Intrinsic Value: Add the sum of the present values of the explicit FCFs and the present value of the Terminal Value to arrive at the total Intrinsic Value of the company or asset.

Example Calculation:

Let's use the default values in the calculator:

• Current Year FCF: $1,000,000
• FCF Growth Rate (Explicit Period): 5%
• Number of Explicit Forecast Years: 5
• Terminal Growth Rate: 2%
• Discount Rate (WACC): 10%

Step 1: Project Explicit FCFs and their Present Values

• Year 1 FCF: $1,000,000 * (1 + 0.05) = $1,050,000
• PV Year 1 FCF: $1,050,000 / (1 + 0.10)^1 = $954,545.45
• Year 2 FCF: $1,050,000 * (1 + 0.05) = $1,102,500
• PV Year 2 FCF: $1,102,500 / (1 + 0.10)^2 = $911,157.02
• Year 3 FCF: $1,102,500 * (1 + 0.05) = $1,157,625
• PV Year 3 FCF: $1,157,625 / (1 + 0.10)^3 = $869,703.01
• Year 4 FCF: $1,157,625 * (1 + 0.05) = $1,215,506.25
• PV Year 4 FCF: $1,215,506.25 / (1 + 0.10)^4 = $829,700.03
• Year 5 FCF: $1,215,506.25 * (1 + 0.05) = $1,276,281.56
• PV Year 5 FCF: $1,276,281.56 / (1 + 0.10)^5 = $792,490.04

Sum of PV of Explicit FCFs = $954,545.45 + $911,157.02 + $869,703.01 + $829,700.03 + $792,490.04 = $4,357,595.55

Step 2: Calculate Terminal Value (TV)

• FCF Year 6 (FCF_Year_N+1): $1,276,281.56 * (1 + 0.02) = $1,301,807.20
• Terminal Value: $1,301,807.20 / (0.10 – 0.02) = $1,301,807.20 / 0.08 = $16,272,590.00

Step 3: Calculate Present Value of Terminal Value (PV_TV)

• PV_TV: $16,272,590.00 / (1 + 0.10)^5 = $16,272,590.00 / 1.61051 = $10,104,040.00

Step 4: Total Intrinsic Value

• Total Intrinsic Value = Sum of PV of Explicit FCFs + PV_TV
• Total Intrinsic Value = $4,357,595.55 + $10,104,040.00 = $14,461,635.55

Limitations of DCF:

While powerful, DCF is highly sensitive to its inputs. Small changes in the growth rate, terminal growth rate, or discount rate can lead to significant differences in the intrinsic value. It relies heavily on assumptions about the future, which are inherently uncertain. Therefore, DCF is often used in conjunction with other valuation methods to provide a more comprehensive view.