Why is dcf the best method

Discounted cash flow DCF is a valuation method used to estimate the value of an investment based on its expected future cash flows. DCF analysis attempts to figure out the value of an investment today, based on projections of how much money it will generate in the future.

This applies to the decisions of investors in companies or securities, such as acquiring a company or buying a stock, and for business owners and managers looking to make capital budgeting or operating expenditures decisions. The formula for DCF is:.

The purpose of DCF analysis is to estimate the money an investor would receive from an investment, adjusted for the time value of money. The time value of money assumes that a dollar today is worth more than a dollar tomorrow because it can be invested. As such, a DCF analysis is appropriate in any situation wherein a person is paying money in the present with expectations of receiving more money in the future.

DCF 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 equal to or greater than the value of the initial investment. If the value calculated through DCF is higher than the current cost of the investment, the opportunity should be considered. 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.

The investor must also determine an appropriate discount rate for the DCF model, which will vary depending on the project or investment under consideration, such as the company or investor's risk profile and the conditions of the capital markets. If the investor cannot access the future cash flows, or the project is very complex, DCF will not have much value and alternative models should be employed. When a company analyzes whether it should invest in a certain project or purchase new equipment, it usually uses its weighted average cost of capital WACC as the discount rate when evaluating the DCF.

The WACC incorporates the average rate of return that shareholders in the firm are expecting for the given year. Therefore, the discounted cash flows for the project are:.

Because this is a positive number, the cost of the investment today is worth it because the project will generate positive discounted cash flows above the initial cost.

Dividend discount models, such as the Gordon Growth Model GGM for valuing stocks, are examples of using discounted cash flows. The main limitation of DCF is that it requires many assumptions. For one, an investor would have to correctly estimate the future cash flows from an investment or project.

The future cash flows would rely on a variety of factors, such as market demand , the status of the economy, technology, competition, and unforeseen threats or opportunities. Estimating future cash flows to be too high can result in choosing an investment that might not pay off in the future, hurting profits. Estimating cash flows to be too low, which would make the investment appear costly, could result in missed opportunities.

Choosing a discount rate for the model is also an assumption and would have to be estimated correctly for the model to be worthwhile. Calculating the DCF involves three basic steps—one, forecast the expected cash flows from the investment. Two, you select a discount rate, typically based on the cost of financing the investment or the opportunity cost presented by alternative investments. In effect, UFCF allows the analyst to separate the Cash flows produced by the business from the structure of the ownership and liabilities of the business.

The analyst should test several reasonable assumption scenarios to derive a reasonable valuation range. The following sources can help provide needed information to produce a high-quality DCF analysis:. In order to calculate Free Cash Flow projections, you must first collect historical financial results. This derives a much more accurate representation of the Cash that a company generates than does pure Net Income:. The good news is that these Cash flow figures are the least difficult to project, because the closer we are to an event, the more visibility we have about that event.

The bad news, of course, is that any error in projecting these figures will have a large impact on the output of the analysis. FCF is derived by projecting the line items of the Income Statement and often Balance Sheet for a company, line by line. The assumptions driving these projections are critical to the credibility of the output.

Below, we will walk you through a simple example of how to do this. Depreciation is a non-Cash expense, meaning the company books Depreciation as an expense on the income statement for GAAP Generally Accepted Accounting Principles purposes but in reality, no Cash was actually spent. It is an expense of Capital Expenditures made in prior years. Similarly, CapEx must be subtracted out, because it does not appear in the Income Statement, but it is an actual Cash expense.

It should be noted that Amortization acts in much the same way as Depreciation, but is used to expense non-Fixed Assets rather than Fixed Assets.

An example of this would be Amortization on the value of a patent purchased when acquiring a company that owned it. We will go into more detail on determining the discount rate, r , in the WACC section of this chapter.

The difference between Present Value and Net Present Value is simply to incorporate any cash outflows that might occur in the scenario. Terminal Value represents the value of the cash flows after the projection period.

Projections only go out so far in the DCF i. Besides explicitly considering the business drivers involved, DCF allows investors to incorporate key changes in the business strategy in the valuation model, which otherwise will go unreflected in other valuation models like relative, APV, etc.

While other methods like relative valuation are fairly easier to calculate, their reliability becomes questionable when the entire sector or market is over-valued or under-valued. DCF cuts across through this quandary and predicts the best possible instrinsic value. Most importantly, DCF model can be used as a sanity check. DCF Valuation is extremely sensitive to assumptions related to perpetual growth rate and discount rate. It works best only when there is a high degree of confidence about future cash flows.

While forecasting cash flows for the next few years is difficult, pushing them out perpetually mandatory for DCF Valuation becomes almost impossible. As such, DCF method is susceptible to error if not properly accounted for these inputs. Even a minor variation in the assumptions on terminal year can have a significant impact on the final valuation.