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Understanding discounted cash flow (DCF)

DCF, which is an indispensable tool to evaluate debt instruments, is also useful in the equity world. Here is what it means.

Understanding discounted cash flow (DCF)

Valuation metrics are used to comprehensively assess a company's performance, financial health and future prospects. Not surprisingly, both shareholders and creditors hold much interest in these metrics. Like enterprise value, the DCF or discounted cash flow is an absolute valuation method, which means that the end goal is to arrive at a specific rupee valuation.

The DCF method is based on one of the strongest and easily understandable principles of finance - the time value of money. In simple words, this principle asserts that the worth of one rupee is more today than tomorrow. Let's take the example of a regular household investment product, the ubiquitous fixed deposit (FD). If you deposit Rs 10 lakh in your FD today at an interest rate of 6 per cent, then the worth of your FD tomorrow would be Rs. 10,00,164. This extra Rs 164 is the additional amount that you have earned in one day. While this is normally called 'interest' and typically thought of only in the context of debt investments, the underlying principle of growth in the expected value of money is equally valid (with some modifications) in the world of equity investments.

The DCF method is, in essence, a reverse-engineering process, which considers a share as nothing but a stream of future cash flows. To put a value on this 'stream', investors begin with estimating both the quantum and the timing of these expected future cash flows. These include intermediary payments (dividends, buybacks etc) and a terminal payment (when finally disposing of the shares). After choosing a specific time frame, all that investors have to do is to 'discount' these future cash flows by using an acceptable discount rate to arrive at a present value.

For example, let's take a situation where the investment time frame is three years, the company is expected to pay Rs 10 per year as dividends and the share price at the end of three years is expected to be Rs 300. Now if our expected rate of return is 18 per cent, then the DCF method would give a current share price of Rs 204.3. This means that in order for us to achieve the targeted return of 18 per cent (provided all our assumptions turn out true), we shouldn't pay a price more than Rs 204.3. Paying anything more would decrease our returns and vice versa.

Interestingly, when it comes to implementing the DCF method, different routes can be followed. To begin with, investors can decide which payment to discount. Dividends and free cash flows are the usual favourites here. The next step is to estimate the discount rate. There are sophisticated ways (CAPM, WACC, Historical etc.) but one can even use a (reasonably) desirable rate of return. And finally, when it comes to estimating the terminal value, investors again have a choice between using a complex method ( Gordon Growth Model) or the same multiple as what the stock is currently being traded at.

Advantages
The DCF is very strongly grounded in theoretical finance. The principle of time value of money is widely accepted across the world and can be applied for valuing both companies (based on dividends, free cash flows etc.) and individual projects. Further, this method is more suitable to value stable, mature companies which are likely to pay a steady stream of cash flows.

Disadvantages
The primary disadvantage is the number of inputs that go into the model. All the three inputs - discount rate, intermediary cash flows and terminal value - are subject to different underlying assumptions.

Another disadvantage is that the valuation calculated through this method is predominantly based on the terminal value, which is very difficult to predict. The actual terminal value, which is only realised at the end of the investment period, will be heavily subject to the prevailing market conditions at that time, making it even more difficult to predict than the intermediary cash flows, which are themselves uncertain.

But investors need to understand that investing is ultimately based on faith and the expectation that a brighter future awaits those who are brave enough to take the risk today.

Also read in this series

Understanding the P/E ratio
Understanding the P/B ratio
Understanding enterprise value