Discounted Cash Flow (DCF) Calculator
Estimate the intrinsic value of an asset or company by projecting its future free cash flows and discounting them back to the present.
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.
How DCF Works
At its core, the DCF method 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 opportunity cost.
Key Components of a DCF Analysis:
- Free Cash Flow (FCF) Projections: These are the cash flows generated by a company or project after accounting for operating expenses and capital expenditures. The calculator asks for FCF for specific forecast years (e.g., 5 years). Accurate FCF projections are critical and often the most challenging part of a DCF analysis.
- Discount Rate (WACC): The Weighted Average Cost of Capital (WACC) is typically used as the discount rate. It represents the average rate of return a company expects to pay to finance its assets. It's the rate used to bring future cash flows back to their present value. A higher discount rate means future cash flows are worth less today.
- Terminal Value (TV): This represents the value of the company or asset beyond the explicit forecast period (e.g., after year 5). It's often calculated using the Gordon Growth Model, which assumes a constant growth rate of FCF into perpetuity, or by applying an exit multiple to a financial metric in the terminal year. Our calculator uses the Gordon Growth Model.
- Perpetual Growth Rate: Used in the Gordon Growth Model for Terminal Value, this is the assumed constant rate at which the company's free cash flows will grow indefinitely after the explicit forecast period. This rate should generally be conservative and not exceed the long-term nominal GDP growth rate of the economy in which the company operates.
The DCF Formula:
The general formula for DCF is:
DCF Value = FCF₁/(1+WACC)¹ + FCF₂/(1+WACC)² + ... + FCFₙ/(1+WACC)ⁿ + TV/(1+WACC)ⁿ
Where:
FCF₁...FCFₙare the Free Cash Flows for each forecast year.WACCis the Weighted Average Cost of Capital (Discount Rate).nis the number of forecast years.TVis the Terminal Value.
The Terminal Value (TV) using the Gordon Growth Model is calculated as:
TV = (FCFₙ * (1 + Perpetual Growth Rate)) / (WACC - Perpetual Growth Rate)
Interpreting the Results
The calculated DCF Value represents the estimated intrinsic value of the asset or company today. If this intrinsic value is higher than the current market price (for a publicly traded company), the asset might be considered undervalued and a good investment opportunity. Conversely, if the intrinsic value is lower than the market price, it might be overvalued.
Limitations of DCF
While powerful, DCF analysis relies heavily on assumptions, especially regarding future cash flows, the discount rate, and the perpetual growth rate. Small changes in these assumptions can lead to significant differences in the estimated intrinsic value. Therefore, it's often used in conjunction with other valuation methods and sensitivity analysis.
Example Calculation:
Let's use the default values in the calculator:
- FCF Year 1: $100,000
- FCF Year 2: $120,000
- FCF Year 3: $140,000
- FCF Year 4: $160,000
- FCF Year 5: $180,000
- Perpetual Growth Rate: 2.5% (0.025)
- Discount Rate (WACC): 10% (0.10)
1. Present Value of Explicit FCFs:
- PV FCF1 = $100,000 / (1 + 0.10)¹ = $90,909.09
- PV FCF2 = $120,000 / (1 + 0.10)² = $99,173.55
- PV FCF3 = $140,000 / (1 + 0.10)³ = $105,186.07
- PV FCF4 = $160,000 / (1 + 0.10)⁴ = $109,279.90
- PV FCF5 = $180,000 / (1 + 0.10)⁵ = $111,760.09
2. Calculate Terminal Value (TV):
- FCF Year 6 (for TV) = FCF Year 5 * (1 + Perpetual Growth Rate) = $180,000 * (1 + 0.025) = $184,500
- TV = FCF Year 6 / (WACC – Perpetual Growth Rate) = $184,500 / (0.10 – 0.025) = $184,500 / 0.075 = $2,460,000.00
3. Present Value of Terminal Value (PV_TV):
- PV_TV = TV / (1 + WACC)⁵ = $2,460,000 / (1 + 0.10)⁵ = $2,460,000 / 1.61051 = $1,527,400.00
4. Sum all Present Values:
- Total DCF Value = $90,909.09 + $99,173.55 + $105,186.07 + $109,279.90 + $111,760.09 + $1,527,400.00 = $2,043,708.70
This example demonstrates how the calculator arrives at the intrinsic value based on the provided inputs.