Discounted Cash Flow Law and Legal Definition
Discounted Cash Flow (DCF) analysis is a technique for determining what a business is worth today in light of its cash yields in the future. It is routinely used by people buying a business. It is based on cash flow because future flow of cash from the business will be added up. It is called discounted cash flow because in commercial thinking $100 in your pocket now is worth more than $100 in your pocket a year from now. Why? You can at minimum put your $100 in the bank and it will earn you at least 3 to 4 percent interest. A year from now it will be worth $104. Therefore, looked at the other way, $100 received a year from now is worth only $96.15 today if the discount rate is 4 percent (96.15 × 1.04 = 100). If your current cash could earn 10 percent interest, the future $100 would be worth only $90.9 in today's valuation.
The elements of DCF therefore are 1) the period of time to be used for evaluation, say a business life of 10 years, 2) the flows of cash that will occur every year in that business as best as you can guess, 3) your own internal discount rate or, put another way, what your money could earn if invested in something else of equivalent risk. The calculation itself is very easily done in a spreadsheet with a simple formula (shown below). What is really important in DCF is assessing the business and accurately predicting what flows of cash it will yield.
Obtaining the annual cash flow to be discounted is done as follows:
- Start with Net Income After Tax.
- Add Depreciation for the year (because depreciation is not a cash cost).
- Deduct Change in working capital from the previous year. This change may actually be negative, in which case this operation will add to cash. In a growing operation it will be positive and so will require cash.
- Deduct Capital expenditures.
Working capital is current assets less current liabilities. Unless the DCF is very detailed, the usual items included are the "biggies," receivables and inventories on the asset side and payables on the liabilities side, only changes being counted. If receivables were $100,000 at the beginning of the year and $130,000 at the end, $30,000 is the change. If inventories decreased from $40,000 to $35,000, the change is −$5,000—for a net change in assets of $25,000. Assume payables went from $80,000 to $110,000. The change in liabilities then is $30,000. Change in assets less liabilities is therefore −$5,000. This amount is deducted, from net income after tax, but deducting a negative causes it to be added. In effect the situation in this case means that the cash position of the business has improved. Finally capital expenditures, a flat drain on cash, are deducted.
These estimates of the cash flow are repeated for every year of the forecast period, in this case a ten-year cycle. To derive the crucial starting number, net income after tax, the analyst must, of course, project sales and costs assuming some reasonable growth rate for the operation—usually based on the target company's history. He or she must derive necessary inventory levels to support projected sales—and also calculate additions to capital based on capacity at the beginning of the period.
Most DCFs end by assuming that at the end of the cycle the company will be sold again at some conservative multiple of its after-tax earnings. This number is then plugged in as a "residual value" for the 11th year.
Next, and crucially, the analyst must determine what discount rate to use. Suppose the prospective buyer of the company enjoys a net return on its own, current investments in its own business of 16.7 percent. It may use that rate as a minimum or as an acceptable average return.
Now, with the annual cash flows neatly keyed into a spreadsheet down a column, each row representing a year—and the 11th year carrying the "resale residual," application of a discount formula can be applied. The formula for each row is quite simple:
PV = FV × (1 + dr)λ−n.
In this formula, PV stands for present value, namely right now, in the year of analysis. FV is the cash projected for one of the years in the future. dr is the discount rate. The 16.7 percent would be entered as .167. The caret symbol stands for exponentiation; n is the number of years; the negative n is the negative value of the year. Thus year 1 is −1, year 2 is −2 and so on.
Let us assume that the years begin with 2007 and that these years are in column A, beginning on row 5 of our spreadsheet. The cash flows are in column B, also beginning on row 5. Then, the formula in column C, row 5, will read:
Replicating this formula down to the last row, row 15 (which will start with 2017 and will hold the residual), will automatically transform the projected cash flows into their discounted equivalents. Simply adding them up will result in the discounted cash flow value of the business. Assume that the cash flows in column B are (with 1,000s suppressed) 135, 137, 138, 142, 145, 150, 150, 170, 169, 175 and the last, the residual, is 675, the discounting formula will produce the values 116, 101, 87, 77, 67, 59, 51, 41, 42, 37, and, finally, 123. These values will add to 809. In actual cash, as projected, the business will generate $2,186,000, the sum of the first set of numbers. But by discounting using the 16.7 rate, that value, today, is worth $809,000. Thus if the asking price is at or below that value, the deal is good. If it is higher, the prospective buyer should probably pass.
Discounted cash flow analysis is almost always applied when a company is thinking of purchasing another. As shown above, the technique is ultimately simple enough if applied with care. An ordinary spreadsheet is enough to do the job. But the real job is not really the application of a math formula.
As David Harrison pointed out writing in Strategic Finance, "The simplicity of a DCF valuation is probably what contributes most to underestimating the time required for valuation jobs in the first place. Think about it—it isn't the DCF calculations that require any time; they run in an instant. But the DCF is only as good as its inputs, so that old adage, 'you are what you eat;' couldn't be truer with respect to DCF. Good estimates yield good valuations; bad estimates … well, you know the rest. How do we get a reasonable range of estimates for our discounted cash flow? Therein lies the problem—the gremlin that eats away our time, drives us crazy, and makes us feel like plodding amateurs."
DCF, in other words, greatly depends on many much fuzzier issues, the most uncertain of which is how the future will treat the business we are thinking of buying. Here, as always, a thorough knowledge of the industry, conservative assumptions, due diligence in looking at the business in detail, especially visits with its clients and suppliers, and also a certain humility on the buyer's part are of crucial importance. Many owners have great confidence in their own abilities and a low estimate of the seller's. That should be a much bigger red flag than a lackluster DCF number.
"Discounted Cash Flow." Chartered Management Institute: Checklists: Managing Information and Finance. October 2005.
Glasgow, Bo. "Metrics and Measures: Cash flow-based analysis rules the roost." Chemical Market Reporter. 25 November 2002.
Harrison, David S. "Business Valuation Made Simple: It's all about cash." Strategic Finance. February 2003.
Makholm, Jeff D. "In Defense of the 'Gold Standard': It is hard to foresee abandoning the discounted cash flow method relied upon so heavily for the past couple of decades." Public Utilities Fortnightly. 15 May 2003.
"What Are You Worth? For sellers, it's back to the future, but for buyers it's here and now." Financial Planning. 1 May 2005.