9.18 DCF (discounted cash flow)
DCF method for valuation
Discounted cash flow method is a method of valuing a company, using the concept of the Time Value of Money. It is a valuation method used to estimate the attractiveness of an investment opportunity. In DCF method, all the future cash flows are estimated and discounted to give their present values. A discount rate is chosen which reflects the risk (the higher the risk ,the higher the discount rate) and this is used to discount all forecast future cash flows to calculate a present value.
Let’s see what exactly we mean by estimated future cash flows and discount rate.
Estimated Future Cash Flow:
Estimated future cash flows are simply the future cash flows the underlying company is going to generate. Many variables go into estimating those cash flows, but among the most important are the company's future sales growth and profit margins. When predicting a company's revenue growth, it's important to consider a variety of factors, including industry trends, economic data, and a company's competitive advantages.
Discount Rate:
It is the interest rate used in determining the present value of future cash flows.
For example, let's say you expect Rs 1, 000 in one year's time. To determine the present value of this Rs 1,000 (what it is worth to you today) you would need to discount it by a particular rate of interest (often the risk-free rate or weighted average cost of capital). Assuming a discount rate of 10 per cent, the Rs 1, 000 in a year's time would be the equivalent of Rs 909.09 to you today (1000/ [1.00 + 0.10]).
Discount rate should reflect two things:-
- The Time Value of Money (investors would rather have cash immediately than having to wait and must therefore be compensated by paying for the delay)
- The risk premium that reflects the extra return that investors demand because they want to be compensated for the risk that the cash flows might not materialize after all.
Example: To show how discounted cash flow analysis is performed, consider the following simplified example.
- Ravi buys a house for Rs 100,000. Three years later, he expects to be able to sell this house for Rs 150,000.
Simple subtraction suggests that the value of his profit on such a transaction would be Rs 150, 000 – Rs 100, 000 = Rs 50, 000, or 50 per cent. If that Rs 50,000 is amortized over the three years, his implied annual return (known as the internal rate of return) would be about 14.5 per cent. Looking at those figures, he might be justified in thinking that the purchase looked like a good idea.
However, since three years have passed between the purchase and the sale, any cash flow from the sale must be discounted accordingly. At the time Ravi buys the house, the 3-year Government Bond rate is 5percent per annum. Government Bonds are generally considered to be inherently less risky than real estate, since the value of the Bond is guaranteed by the Government and there is a liquid market for the purchase and sale of a Government Bond. If he hadn't put his money into buying the house, he could have invested it in the relatively safe Government Bond instead. This 5 per cent per annum can therefore be regarded as the risk-free interest rate for the relevant period (3 years).
Using the DPV(discounted present value) formula above (FV = Rs 150,000, i = 0.05, n = 3), that means that the value of Rs 150,000 received in three years actually has a present value of Rs 129,576 (rounded off). In other words we would need to invest Rs 129,576 in a Govt-Bond now to get Rs 150,000 in 3 years almost risk free. This is a quantitative way of showing that money in the future is not as valuable as money in the present (Rs 150,000 in 3 years isn't worth the same as Rs 150,000 now; it is worth Rs 129,576 now).
Subtracting the purchase price of the house (Rs 100, 000) from the present value results in the net present value of the whole transaction, which would be Rs 29, 576 or a little more than 29 per cent of the purchase price.