DCF Formula (Discounted Cash Flow)

What is DCF Formula (Discounted Cash Flow)?

Discounted Cash Flow (DCF) formula is an Income-based valuation approach and helps in determining the fair value of a business or security by discounting the future expected cash flows. Under this method, the expected future cash flows are projected up to the life of the business or asset in question, and the said cash flows are discounted by a rate called the Discount Rate to arrive at the Present Value.

The basic formula of DCFDCFDiscounted cash flow analysis is a method of analyzing the present value of a company, investment, or cash flow by adjusting future cash flows to the time value of money. This analysis assesses the present fair value of assets, projects, or companies by taking into account many factors such as inflation, risk, and cost of capital, as well as analyzing the company's future performance.read more is as follows:

DCF Formula =CFt /( 1 +r)t

Where,

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For eg:
Source: DCF Formula (Discounted Cash Flow) (wallstreetmojo.com)

It is not possible to forecast cash flowForecast Cash FlowCash flow forecasting is forecasting or anticipating the cash inflow and outflow for the future period by the management of the business to make sure that the business will have sufficient funds to carry out the activities on a regular basis, and if there is any shortfall, they has to plan for alternate sources of funding for the business. read more till the whole life of a business, and as such, usually, cash flows are forecasted for a period of 5-7 years only and supplemented by incorporating a Terminal Value for the period thereafterTerminal Value For The Period ThereafterTerminal Value is the value of a project at a stage beyond which it's present value cannot be calculated. This value is the permanent value from there onwards. read more. Terminal Value is basically the Estimated Value of business beyond the period for which cash flows are forecasted. It is a very important part of the Discounted Cash flow formula and accounts for as much as 60%-70% of the Firm’s value and thus warrants due attention.

The terminal value of a business is calculated using the Perpetual growth rate method or Exit Multiple Method.

Under the Perpetual Growth Rate Method, the terminal value is calculated as

TVn= CFn  (1+g)/( WACC-g)

Where,

  • TVn Terminal Value at the end of the specified period
  • CFn represents the cash flow of the last specified period
  • g is the growth rate
  • WACC is the Weighted Average Cost of Capital.

Under the Exit Multiple methods, the terminal value is calculated using multiple of EV/EBITDAMultiple Of EV/EBITDAEV to EBITDA is the ratio between enterprise value and earnings before interest, taxes, depreciation, and amortization that helps the investor in the valuation of the company at a very subtle level by allowing the investor to compare a specific company to the peer company in the industry as a whole, or other comparative industries.read more, EV/SalesEV/SalesEV to Sales Ratio is the valuation metric which is used to understand company’s total valuation compared to its sales. It is calculated by dividing enterprise value by annual sales of the company i.e. (Current Market Cap + Debt + Minority Interest + preferred shares – cash)/Revenueread more, etc., and giving a multiplier to it. For instance, using Exit multiple ones can value the Terminal with ‘x’ times the EV/EBITDA sale of the business with the cash flow of Terminal Year.

FCFF and FCFE used in DCF Formula Calculation

The discounted Cashflow (DCF) formula can be used to value the FCFFFCFFFCFF (Free cash flow to firm), or unleveled cash flow, is the cash remaining after depreciation, taxes, and other investment costs are paid from the revenue. It represents the amount of cash flow available to all the funding holders – debt holders, stockholders, preferred stockholders or bondholders.read more or Free Cash flow to EquityFree Cash Flow To EquityFCFE (Free Cash Flow to Equity) determines the remaining cash with the company's investors or equity shareholders after extending funds for debt repayment, interest payment and reinvestment. It is an indicator of the company's equity capital managementread more.

Let’s understand both and then try to find the relation between the two with an example:

#1 – Free Cashflow to Firm (FCFF)

Under this DCF calculation approach, the entire value of the business, which includes besides equities, the other claim holders in the firm as well (debt holders, etc.). The cash flows for the projected period under FCFF are computed as under

These Cash flows calculated above are discounted by the Weighted Average Cost of Capital (WACC), which is the cost of the different components of financing used by the firm, weighted by their market value proportions.

WACC=Ke*(1-DR) + Kd*DR

where

Cost of Equity (Ke) is computed by using the CAPMCAPMThe Capital Asset Pricing Model (CAPM) defines the expected return from a portfolio of various securities with varying degrees of risk. It also considers the volatility of a particular security in relation to the market.read more as under:

Ke=Rf + β * (Rm-Rf)

where,

Finally, all the numbers are added to arrive at the enterprise value as under:

Enterprise Value Formula  = PV of the (CF1,CF2…..CFn) + PV of the TVn

#2 – Free Cashflow to Equity (FCFE)

Under this DCF Calculation method, the value of the equity stake of the business is calculated. It is obtained by discounting the expected cash flows to equity, i.e., residual cash flows after meeting all expenses, tax obligations, and interest and principal paymentsPrincipal PaymentsThe principle amount is a significant portion of the total loan amount. Aside from monthly installments, when a borrower pays a part of the principal amount, the loan's original amount is directly reduced.read more. The cash flows for the projected period under FCFE are calculated as under:

FCFE=FCFF-Interest * (1-tax rate)-Net repayments of debt

The above cash flows for the specified period are discounted at the cost of equity (Ke), which was discussed above, and then the Terminal Value is added (discussed above) to arrive at the Equity Value.

Example of DCF Formula (with Excel Template)

You can download this DCF Formula EXCEL Template here – DCF Formula EXCEL Template

Let’s understand how Enterprise/Firm Value and Equity Value is calculated using a Discounted Cash Flow Formula with the help of an example:

The following data is used for the calculation of Value of Firm and Value of Equity using the DCF Formula.

DCF formula example 1.1

Also, assume that cash at hand is $100.

Valuation using FCFF Approach

First, we have calculated the Value of the Firm using the DCF Formula as follows.

Cost of Debt

DCF formula example 1.2

Cost of Debt is 5%

WACC

DCF formula example 1.3
  • WACC = 13.625% ($1073/$1873)+5%( $800/$1873)
  • = 9.94%

Calculation of Value of Firm using DCF Formula

DCF formula example 1.5

Value of Firm= PV of the (CF1, CF2…CFn) + PV of the TVn

Value of Firm using DCF Formula

example 1.4

Thus Value of the Firm using a Discounted Cash flow formula is $1873.

  • Value of Equity = Value of the Firm – Outstanding Debt + Cash
  • Value of Equity = $1873 – $800+ $100
  • Value of Equity = $1,173

Valuation using FCFE Approach

Let us now apply DCF Formula to calculate the value of equity using the FCFE approach

example 1.6

Value of Equity= PV of the (CF1, CF2…CFn) + PV of the TVn

Here Free Cash flow to Equity (FCFE) is discounted using the Cost of Equity.

  • Value of Equity= ($50/1.13625) + ($60/1.13625^2) + ($68/1.13625^3) + ($76.2/1.13625^4) + ({$83.49+$1603}/1.13625^5)

Value of Equity using DCF Formula

example 1.7

Thus Value of Equity using a Discounted Cash flow (DCF) formula is $1073.

Total Value of Equity = Value of Equity using DCF Formula + Cash

  • $1073 + $100 = $1,173

Conclusion

The discounted Cash flow (DCF) formula is a very important business valuation tool which finds its utility and application in the valuation of an entire business for mergers acquisition purpose. It is equally important in the valuation of Greenfield Investments. It is also an important tool in the valuation of securities such as Equity or a Bond or any other income generating asset whose cash flows can be estimated or modeled.

Recommended Articles

This article has been a guide to DCF Formula. Here we discuss how to calculate the Fair Value of Firm and Equity using the Discounted Cash Flow Formula along with the practical examples and downloadable excel sheet. You can learn more about accounting from the following articles –

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