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Discounted Cash Flow (DCF) Explained
Discounted cash flow (DCF) is one of the most important methods used for evaluating the value of a company, project or asset based on future cash flows. It estimates the value of all future cash flows and then discounts them to find a present value. This present value is used for assessing the value of a potential investment. Usually, if the value is greater than the cost of the investment then it is worth considering.
A Little More on Discounted Cash Flow
The method followed in calculating DCF is
CF = Cash Flow
r = discount rate (WACC)
DCF is also called the Discounted Cash Flows Model.
DCF analysis is widely used in finance including investment finance, real estate development, corporate finance, and others.
It evaluates how much money an investor would get from an investment. The estimate is adjusted for the time value of money. According to the time value of money, a dollar is more valuable today than tomorrow.
It becomes difficult to use the DCF method in cases of large and complicated investment. Selecting the cash flow to be discounted is a challenge in such cases. Also, if the investor does not have access to the future cash flow, this method cannot be applied.
When using this method for business purchases, the new owners can evaluate the firm with the estimated future cash flow.
DCF is far more useful for evaluating individual investments or projects. It enables the firm and the individual to predict confidently.
Regardless of the purpose, the discount cash flow method assumes a discount rate. There are different methods to calculate the correct discount rate. It can be a simple percentage or a value calculated by Weighted Average Cost of Capital (WACC).
References for Discounted Cash Flow
Academic Research on Discounted Cash Flow
· Reconciling value estimates from the discounted cash flow model and the residual income model, Lundholm, R., & O’keefe, T. (2001). Contemporary Accounting Research, 18(2), 311-335. This paper shows why the discounted cash flow (DCF) model and the residual income (RI) model can achieve wildly different estimates of equity value when used by academics versus private-sector users. Both models are derived from the same assumptions, but those assumptions are often applied inconsistently, and those inconsistencies can create enormous value differences. Research literature and practical applications surrounding both methods are examined.
· The market pricing of cash flow forecasts: Discounted cash flow vs. the method of “comparables”, Kaplan, S. N., & Ruback, R. S. (1996). Journal of applied corporate finance, 8(4), 45-60.
· A discounted cash flow approach to property-liability insurance rate regulation, Myers, S. C., & Cohn, R. A. (1987). In Fair Rate of Return in Property-Liability Insurance (pp. 55-78). Springer, Dordrecht. This work seeks to find a fair system of rate regulation that equally benefits policy holders and insurance company stockholders. This effort usually takes the form of finding a fair rate of return using the discounted cash flows (DCF) method.
· Multi-period discounted cash flow rate-making models in property-liability insurance, Cummins, J. D. (1990). Journal of Risk and Insurance, 79-109. This article examines two of the most popular models using the discounted cash flow (DCF) approach as they are utilized in the liability insurance industry. The Myers-Cohn (MC) model and the National Council on Compensation Insurance (NCCI) model are weighed against each other and the differing results are analyzed.
· Discounted cash flow in historical perspective, Parker, R. H. (1968). Journal of Accounting Research, 58-71. This article presents a historical overview of the discounted cash flow (DCF) method prior to 1950. The author begins the survey as far back as the 13th century and examines how this practiced has changed over time.
· Discounted cash flow: accounting for uncertainty, French, N., & Gabrielli, L. (2005). Discounted cash flow: accounting for uncertainty. Journal of Property Investment & Finance, 23(1), 75-89. This paper explains the concept of the discounted cash flow (DCF) method of valuation, but recognizes the fact that uncertainty is always a factor that taints the results. The authors take a deeper look at the DCF method and offer an extended analysis that incorporates some uncertainty into the results. This new method helps to address some of the shortcomings of the traditional DCF model.
· The accuracy of Price‐Earnings and discounted cash flow methods of IPO equity valuation, Berkman, H., Bradbury, M. E., & Ferguson, J. (2000). Journal of International Financial Management & Accounting, 11(2), 71-83. This paper examines 45 newly listed firms on the New Zealand Stock Exchange to compare the valuation estimate that comes from the discounted cash flow (DCF) method versus actual market price. The results find that the median pricing error is around 20% of the market price scaled by book value.
· Firm valuation: comparing the residual income and discounted cash flow approaches, Plenborg, T. (2002). Scandinavian Journal of Management, 18(3), 303-318. This paper does a deep-dive that compares the discounted cash flow (DCF) approach of valuation to the residual income model, which is an accrual-based valuation approach. The author examines the various analytical motives for choosing between methods, and some of the biases that users may bring with them to their study. Methods of implementation and situational factors regarding both methods are also discussed.
· Using discounted cash flow analysis in an international setting: a survey of issues in modeling the cost of capital, Keck, T., Levengood, E., & Longfield, A. L. (1998). Journal of Applied Corporate Finance, 11(3), 82-99. This analysis attempts to address a common flaw that persists in many corporate valuations of overseas investments. Based on survey results, the authors find that while the discounted cash flows (DCF) approach is commonly applied, it is often used with an inaccurate assignment of weights in segmented markets. Common pitfalls in DCF and composite-approach valuations are discussed, and fixes are offered.
· Three residual income valuation methods and discounted cash flow valuation, Fernandez, P. (2002). SSRN WP, 296945. In this paper the author demonstrates that the standard discounted cash flows (DCF) method yields the same results as three other residual income measures. These three methods that are compared to the DCF are the Economic Profit (EP), Economic Value Added (EVA), and Cash Value Added (CVA) methods. The author walks you through the findings and even clears up some misconceptions about the EP and EVA methods.
· Discounted cash flow with explicit reinvestment rates: Tutorial and extension, McDaniel, W. R., McCarty, D. E., & Jessell, K. A. (1988). Financial Review, 23(3), 369-385. This article surveys the last 30 years of capital budgeting techniques while providing a solid first step to anyone analyzing discounted cash flows. The marginal return on invested capital method is present, along with an explanation of its application. The author also discusses the pros and cons of other common capital budgeting techniques.