Abstract
Discounted cash flow (DCF) is one of the widely used methods used to determine the value of a business or project. The principle behind DCF involves discounting future cash flows to their present value using a discount rate that brings together the expected return and opportunity cost to reflect market value. This paper will discuss the DCF method and its components in greater detail, including its assumptions and limitations. The long-term nature of DCF makes it well-suited to valuing larger-scale operations or investments with a medium to long term outlook.
Introduction
Discounted cash flow, or DCF, is a method of valuing a project or company, based on the present value of its future cash flows. DCF uses the principle that a dollar today is worth more than a dollar in the future due to the potential for the value of a dollar to rise and fall over time. By discounting future cash flows back to their present value, we can calculate the current worth of a project or company.
DCF relies on several assumptions and can be susceptible to biases and errors. Yet, it remains one of the most robust and commonly-used valuation methods due to its ability to account for the time value of money. This paper will discuss the DCF method and its components in greater detail, including its assumptions and limitations.
Principle Behind Discounted Cash Flow
The principle behind DCF is that the value of a project or company can be determined by discounting the stream of future cash flows received from the project or company back to the present value. This can be achieved by first determining the cash flows expected from the project and then discounting those cash flows back to the present using a discount rate. The discount rate reflects the expected return and opportunity cost, reflecting the market value of the project or company.
DCF Components
Discounted Cash Flow consists of four key components:
# Future Cash Flows: The first component of DCF is determining the expected future cash flows associated with the project or company. This includes any cash inflows, such as revenue, as well as any cash outflows associated with the project.
# Discounter rate: The second component is the discount rate, which is used to discount the future cash flows back to their present value. The discount rate takes into account the expected return and opportunity cost, multiplying the future cash flows to reflect the time value of money.
# Initial Expenditure: The third component of DCF is any initial expenditure required for the project or company.
# Terminal Value: The fourth and final component of DCF is the terminal value, which is the value of the project or company at the assumed cutoff date, usually the end of the last forecast period.
Assumptions
Discounted cash flow relies on several assumptions which may introduce biases and errors in the valuation. These assumptions include:
# steady and consistent cash flow: the assumptions that future cash flows will be steady and consistent over time.
# predictable inflation: the assumption that inflation can be accurately predicted over time.
# Risk Free Rate: the assumption that the discount rate used to discount the future cash flows reflects a risk-free rate.
Limitations
Discounted cash flow, as with any method of valuation, also has its limitations. These limitations include:
# Bias and Errors: the assumptions and predictions underlying any cash flow forecast lead to potential biases in the valuation.
# Uncertainty: the nature of future cash flows leads to uncertainty regarding their exact size and timing, leading to potential errors in the valuation.
# Complexity: due to the complex nature of DCF, it can be difficult to fully understand and utilize the method.
Conclusion
Discounted cash flow is a commonly-used method of valuation which relies on discounting future cash flows to their present value. Although the method has its limitations and assumptions, it remains a reliable and robust method for valuing larger-scale operations or investments with a medium to long-term outlook.
