Discounted Cash Flow Analysis
Discounted Cash Flow (DCF) analysis is one of two ways of calculating the fair value of an investment, the other being relative valuation. It says that the fair value of any investment is the present value of its future cash flows. For instance, a bond’s fair value will be present value of the coupons as well as the principals. For a stock investment, the fair value will be the present value of any cash flow received by the stockholder such as dividends or in rarer instances, liquidation value.
DCF analysis has two parts. First we calculate the cash flows we will be discounting and second is the calculation of the discount rate on which we will be discounting the cash flows. Assuming we are already done the above two parts, let us proceed with an example to see how they fit together for calculation of fair value. Let us assume there is an investment that yields a cash flows of $100 an year after investment and then grows 12% thereafter for ten consecutive years. Also let us assume the discount rate is 10%. The fair value of the investment then would be calculated as per the following model:
From the above model, we find that the fair value of such an investment would be approximately $774 in today’s terms. Note that the discount rate becomes the discount factor when we raise it to the appropriate power. Also, if you play around with the model a bit, you will find that if you increase the discount rate, the fair value falls, and vice versa.
You can download the fully functional Excel version of the model here: DCF Model
Common DCF Applications
There are many ways the DCF model is applied, but we’ll talk about two of the most common.
- The most popular DCF application is the FCF analysis where the fair value of the whole firm (inclusive of both debt and equity) is calculated. The discount factor is the Weighted Average Cost of Capital (WACC) and the cash flows are those that belong to both the debt as well as equity holders of the firm.
- Another common application is the Dividend Discount Model (DDM). In the DDM, the future cash flows are simply the dividends. If the dividends are expected to grow at a constant rate, the DDM becomes the Gordon Growth Model (GGM). According to the GGM, if a company is expected to give out a dividend of D next year, which is expected to grow at the rate of g and the discount rate is r, then the fair value of that stock would be:
Fair Value = D/(r-g)