Discounted Cash Flow Analysis

What is Discounted Cash Flow (DCF) Analysis ?

Discounted Cash Flow (DCF) Analysis is a financial valuation method used to estimate the value of an investment based on its expected future cash flows. It can help those considering acquiring a company or buy securities. It can also assist business owners and managers in making capital budgeting or operating expenditure decisions

How does Discounted Cash Flow (DCF) Analysis work?

The purpose of DCF analysis is to estimate the money an investor would receive from an investment, adjusted for the time value of money

For example, assuming a 5% annual interest rate, $1 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 cents because you cannot transfer it to your savings account to earn interest.

Discounted cash flow analysis finds the present value of expected future cash flows using a discount rate. Investors can use the concept of the present value of money to determine whether the future cash flows of an investment or project are greater than the value of the initial investment.

To conduct a DCF analysis, an investor must make estimates about future cash flows and the ending value of the investment, equipment, or other assets.

DCF Formula

The formula for DCF is:

where:

CF1 = The cash flow for year one

CF2 = The cash flow for year two

CFn = The cash flow for additional years

r = The discount rate

DCF Analysis Example

Suppose an FP&A company is planning to buy a 5-year subscription of Cashflowy for $20,000. Cashflowy helps the company by enabling them to serve more customers with the existing man-power and system by increasing the efficiency of creating Reports and Dashboards which will increase the cash flow of the company.

The initial investment is $20,000 and the weighted average cost of capital (WACC) is 5%, and it will last for 5 years, with the following estimated cash flows per year

Adding up all of the discounted cash flows results in a value of $26,614.
By subtracting the initial investment of $20,000, we get a net present value (NPV) of $6,614.

The positive number of $6,614 indicates that the project could generate a return higher than the initial cost

If the subscription had cost $30,000, the NPV would have been -$3386. That would indicate that the subscription cost would be more than the projected return. Thus, it might not be worth making.

The below spreadsheet helps in performing the DCF analysis easily. You can make a copy of this spreadsheet and perform DCF Analysis

Click here for our DCF Template