What is the DCF Formula (Discounted Cash Flow)?

The Discounted Cash Flow (DCF) formula is an income-based valuation approach that helps determine the fair value or security by discounting future expected cash flows. Under this method, the expected future cash flows are projected up to the company’s life or asset, and a discount rate discounts the said cash flows 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,

  • CFt = cash flowCash FlowCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more in period t.R = Appropriate discount rate that has given the riskiness of the cash flows.t = the life of the asset, which is valued.

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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 for the whole life of a business. As such, cash flows are usually predicted for 5-7 years only and supplemented by incorporating a Terminal Value for the period after that Terminal Value For The Period after thatTerminal 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 the estimated business value beyond the period for which cash flows are forecasted. It is an 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 is calculated using the perpetual growth rate or exit multiple methods.

Under the perpetual growth rate method, the terminal value is calculated as: –

TVn= CFn (1+g)/( WACC-g)

  • TVn =Terminal Value at the end of the specified periodCFn = The cash flow of the last specified periodg = the growth rateWACC = The Weighted Average Cost of CapitalWeighted Average Cost Of CapitalThe weighted average cost of capital (WACC) is the average rate of return a company is expected to pay to all shareholders, including debt holders, equity shareholders, and preferred equity shareholders. WACC Formula = [Cost of Equity * % of Equity] + [Cost of Debt * % of Debt * (1-Tax Rate)]read more.

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., giving a multiplier. 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 the terminal year.

FCFF and FCFE used in DCF Formula Calculation

One can use the Discounted Cash Flow Formula (DCF) 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 us 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 includes the other claim holders in the firm besides equities (debt holders, etc.). The cash flows for the projected period under FCFF are computed as under: –

FCFF=Net income after tax+ Interest * (1-tax rate1-tax RCapex or Capital Expenditure is the expense of the company’s total purchases of assets during a given period determined by adding the net increase in factory, property, equipment, and depreciation expense during a fiscal year.read more) + Non-cash expenses (including depreciation & provisions) – Increase in working capital – Capital expenditureCapital ExpenditureCapex or Capital Expenditure is the expense of the company’s total purchases of assets during a given period determined by adding the net increase in factory, property, equipment, and depreciation expense during a fiscal year.read more

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

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

When,

  • Ke = the cost of equityThe Cost Of EquityCost of equity is the percentage of returns payable by the company to its equity shareholders on their holdings. It is a parameter for the investors to decide whether an investment is rewarding or not; else, they may shift to other opportunities with higher returns.read moreKd represents the cost of debtKd Represents The Cost Of DebtCost of debt is the expected rate of return for the debt holder and is usually calculated as the effective interest rate applicable to a firms liability. It is an integral part of the discounted valuation analysis which calculates the present value of a firm by discounting future cash flows by the expected rate of return to its equity and debt holders.read moreDR = The debt proportion in the company.

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)

  • Rf = The risk-free rateRf Represents The Risk-free RateA risk-free rate is the minimum rate of return expected on investment with zero risks by the investor. It is the government bonds of well-developed countries, either US treasury bonds or German government bonds. Although, it does not exist because every investment has a certain amount of risk.read moreRm = The market rate of returnβ = Beta represents a systematic riskSystematic RiskSystematic Risk is defined as the risk that is inherent to the entire market or the whole market segment as it affects the economy as a whole and cannot be diversified away and thus is also known as an “undiversifiable risk” or “market risk” or even “volatility risk”.read more.

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. As a result, 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 equity (Ke) cost we discussed above. Then, the terminal value is added (discussed above) to arrive at the equity value.

Example of DCF Formula (with Excel Template)

The following data is used to calculate the firm’s value and value of equity using the DCF formula.

Also, assume that the cash at hand is $100.

Valuation using FCFF Approach

First, we calculated the firm’s value using the DCF formula.

Cost of Debt

Cost of Debt = 5%

WACC

  • WACC = 13.625% ($1073/$1873)+5%( $800/$1873)WACC = 9.94%.

The calculation of the value of the firm using the DCF formula: –

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

  • Enterprise ValueEnterprise ValueEnterprise value (EV) is the corporate valuation of a company, determined by using market capitalization and total debt.read more = ($90/1.0094) + ($100/1.0094^2) + ($108/1.0094^3) + ($116.2/1.0094^4) + ({$123.49+$2363}/1.0094^5)

Value of Firm using DCF Formula

Thus, the firm’s value using a discounted cash flow formula = $1873.

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

Valuation using FCFE Approach

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

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

Thus, the equity value using a Discounted Cash Flow (DCF) formula =$1073.

  • Total Value of Equity = Value of Equity using DCF Formula + CashTotal Value of Equity = $1073 + $100$1073 + $100 = $1,173

Conclusion

The Discounted Cash flow (DCF) formula is an important business valuation tool that finds its utility and application in valuing an entire business for mergers and acquisitions. It is equally important in the valuation of Greenfield investments. It is also important for evaluating securities such as equity, a bond, or any other income-generating asset whose cash flows can be estimated or modeled.

This article is a guide to DCF Formula. We discuss calculating the fair value of a firm and equity using the discounted cash flow formula, along with examples. You can learn more about accounting from the following articles: –

  • Calculate FCF from EBITDA ExamplesMistakes in DCFWACC FormulaDDM Model