Originally published: 20/09/2019 08:40
Last version published: 06/01/2020 06:21
Publication number: ELQ-27087-3
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# Discounted Cash Flow (DCF) Model

Discounted Cash Flow (DCF) Model in Microsoft Excel that will enable you to estimate the value of an investment.

Description
Discounted cash flow (DCF) is a valuation method used to estimate the value of an investment based on its future cash flows. DCF analysis attempts to figure out the value of a company today, based on projections of how much money it will generate in the future.

DCF analysis finds the present value of expected future cash flows using a discount rate. A present value estimate is then used to evaluate a potential investment. If the value calculated through DCF is higher than the current cost of the investment, the opportunity should be considered.

DCF is calculated as follows:

CF = Cash Flow
r = discount rate (WACC)
DCF is also known as the Discounted Cash Flows Model

How Discounted Cash Flow (DCF) Works
The purpose of DCF analysis is to estimate the money an investor would receive from an investment, adjusted for the time value of money. The time value of money assumes that a dollar today is worth more than a dollar tomorrow.

For example, assuming 5% annual interest, \$1.00 in a savings account will be worth \$1.05 in a year. Similarly, if a \$1 payment is delayed for a year, its present value is \$.95 because it cannot be put in your savings account.

For investors, DCF analysis can be a handy tool that serves as a way to confirm the fair value prices published by analysts. It requires you to consider many factors that affect a company, including future sales growth and profit margins. You’ll also have to think about the discount rate, which is influenced by the risk-free rate of interest, the company’s cost of capital and potential risks to its share prices. All of this helps you gain insight into factors that drive share price, so you’ll be able to put a more accurate price tag on the company’s stock.

A challenge with the DCF model is choosing the cash flows that will be discounted when the investment is large, complex, or the investor cannot access the future cash flows. The valuation of a private firm would be largely based on cash flows that will be available to the new owners. DCF analysis based on dividends paid to minority shareholders (which are available to the investor) for publicly traded stocks will almost always indicate that the stock is a poor value.

However, DCF can be very helpful for evaluating individual investments or projects that the investor or firm can control and forecast with a reasonable amount of confidence.

DCF analysis also requires a discount rate that accounts for the time value of money (risk-free rate) plus a return on the risk they are taking. Depending on the purpose of the investment, there are different ways to find the correct discount rate.

This Best Practice includes
1 Excel Model

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