Discounted Cash Flow Analysis Example: A Complete Guide

What is a discounted cash flow analysis example, and why is it important to you?

Picture this: you’re evaluating two investment opportunities—one is a hot tech startup, and the other is a stable, established company. Which is the better bet? The answer isn’t clear-cut, which is where discounted cash flow (DCF) analysis comes into play.

DCF is a financial tool that forecasts future cash flows and calculates their worth today. Why? The value of a currency fluctuates with time – the dollar today won’t stretch as far a few years from now.

Investors and analysts swear by DCF. About 80% of large companies use it as a key part of their valuation process. It’s not about guessing or gut feelings. DCF brings hard numbers into the equation. Take Netflix, for example. When it first started streaming, analysts used DCF to predict if this risky, unprofitable business model would pay off. Spoiler: it did, big time.

So, what is an example of how a discounted cash flow analysis functions? Let’s say you’re eyeing that tech startup. A DCF analysis will predict its future earnings. Next, it will assess their current value by taking into account potential risks and the time value of money before implementing a discount. While it may appear to be a lucrative opportunity in the future, the current worth might not be worth the investment.

DCF is your primary tool for making informed investment choices in a data-centric environment fueled by financial forecasts. Understanding the discounted cash flow analysis could be the difference between a winning investment and a financial misstep.

Let’s dive deeper.

Table of Contents:

1. What is Discounted Cash Flow (DCF)?
2. Why Would You Use a Discounted Cash Flow Analysis Model?
3. What are the Different DCF Methods?
4. How to Calculate Discounted Cash Flow (DCF)?
5. What are the Advantages and Disadvantages of Discounted Cash Flow Analysis?
6. How to Build a DCF Model?
7. How to Value Stocks Using DCF?
8. How Discounted Cash Flow Impacts Your Small Business?
9. What are the Limitations of Discounted Cash Flow Analysis?
10. What are the Steps in the Discounted Cash Flow Analysis in Excel?
11. Wrap Up

First…

What is Discounted Cash Flow (DCF)?

Definition: The discounted cash flow (DCF) method evaluates investments by projecting future cash receipts and determining their current worth.

The idea is simple: money loses value over time due to inflation and risk.

DCF assists investors in evaluating the present value of a future dollar. This allows them to assess whether an investment is worth pursuing. It’s an essential resource for companies, stakeholders, and evaluators when determining financial choices rooted in anticipated profit prospects.

Why Would You Use a Discounted Cash Flow Analysis Model?

Imagine you’re considering investing in a company but need to determine if it’s genuinely valuable. A discounted cash flow (DCF) evaluation is beneficial in this context. It offers a clearer insight into the prospective investment’s present worth.

Here’s why you should use it.

• Intrinsic value evaluation: DCF enables you to determine a company’s true value beyond just its current market price.
• Future cash flow focus: It emphasizes future cash flows, which show the potential returns an investment might bring.
• Flexibility: You can tweak the model for different scenarios, making it adaptable to changes in market trends.
• Risk adjustment: DCF accounts for risk, factoring in uncertainty and ensuring future profits are not overestimated.
• Comprehensive analysis: It considers a business’s entire financial outlook, from revenues to expenses, giving you the full picture.
• Comparison tool: DCF is perfect for comparing two investments. It will help you decide which offers better long-term value.
• Enduring outlook: This approach goes beyond immediate outcomes. It emphasizes lasting development and sustainable progress.
• Guidance for strategic decisions: Businesses use DCF to guide mergers, acquisitions, and expansion plans. It’s an essential tool for making data-driven decisions with confidence.

What are the Different DCF Methods?

Discounted cash flow (DCF) methods vary in their approach to evaluating the worth of a business or investment. Each one serves a different purpose, depending on what you’re analyzing.

Let’s break them down.

1. Free Cash Flow to Firm (FCFF): This approach determines the cash flow accessible to all stakeholders – both debt and equity investors. It’s great for assessing a company’s overall health before making debt payments.
2. Free Cash Flow to Equity (FCFE): This focuses on the cash flow left over for shareholders after all expenses, taxes, and debt repayments. If you’re an equity investor, FCFE gives you the clearest picture of your potential returns.
3. Adjusted Present Value (APV): APV takes into account the benefits of financing, like tax shields from debt. It’s useful when companies have complex financial structures or are heavily leveraged.
4. Dividend Discount Model (DDM): This model is ideal for companies regularly paying dividends. The Dividend Discount Model (DDM) assesses a company’s worth by calculating the present value of its anticipated future dividend payments. It’s a favorite for investors in mature, dividend-paying businesses.

How to Calculate Discounted Cash Flow (DCF)?

Calculating Discounted Cash Flow (DCF) might sound complex. However, it’s essentially about determining the current worth of future cash streams. Here’s how to do it:

Use the DCF analysis formula below:

Where:

• CF₁ = Cash flow for the first period
• CF₂ = Cash flow for the second period
• CFₙ = Cash flow for “n” period
• n = Number of periods
• r = Discount rate

What are the Advantages and Disadvantages of Discounted Cash Flow Analysis?

Discounted cash flow (DCF) analysis is a valuable method with advantages and limitations. Here are a few important considerations.

Advantages of Discounted Cash Flow (DCF) Analysis:

• Intrinsic value assessment: DCF helps you see the true value of a business beyond market fluctuations.
• Long-term focus: It looks ahead, focusing on an investment’s potential future returns, not just short-term gains.
• Flexibility: You can adjust the model for different scenarios, which makes it versatile for changing conditions.
• Risk adjustment: DCF considers risk factors, helping to prevent an overvaluation of anticipated cash flows.

Disadvantages of DCF Analysis:

• Awareness of assumptions: Minor adjustments in growth or discount rates can significantly alter the outcomes.
• Complexity: It can be tricky, especially for beginners, with many variables to consider.
• Data dependency: DCF relies heavily on accurate financial projections. If the data is off, the analysis can mislead.

How to Build a DCF Model?

Building a Discounted Cash Flow analysis follows a few key steps. This model helps you see the true value of an investment by estimating future cash flows. Let’s simplify the process into three main steps:

1. Collect data and project future cash flows: Gather historical financial data. Then, use this to project the company’s future cash flows, typically over 5-10 years.
2. Calculate the discount rate and discount cash flows: The discount rate reflects the investment’s risk. Once you have it, apply the rate to discount future cash flows back to their present value.
3. Calculate the terminal value and sum the present values: Estimate the company’s value beyond the projection period (terminal value). Add this to the present cash flow value to determine the investment’s total worth.

How to Value Stocks Using DCF?

Valuing stocks with DCF helps determine if a stock is worth its current price by focusing on future earnings. Here’s how to do it:

1. Estimate future cash flows: Start by predicting how much cash the company will generate over 5-10 years.
2. Apply the discount rate to future cash flows: Use a discount rate to adjust those future cash flows back to their present value. This reflects the risk and time value of money.
3. Calculate terminal value and sum present values: Estimate the company’s value after the projection period (terminal value). Then, add that to the discounted cash flows to get the stock’s overall value.

How Discounted Cash Flow Impacts Your Small Business?

Discounted cash flow (DCF) analysis isn’t just for big corporations. It can also have a tangible impact on small businesses, helping guide key decisions. Here’s how DCF can benefit your business:

• Informed decision-making and strategic planning: DCF gives you a clear view of your business’s future cash flows. This helps you make smarter, long-term decisions and plan strategically.
• Attracting investors and valuation insights: A solid DCF analysis shows potential investors your business’s true value. This makes it easier to attract funding and communicate your business’s worth.
• Budgeting and forecasting: DCF helps you predict future financial health, allowing for better budgeting and cash flow management.

What are the Limitations of Discounted Cash Flow Analysis?

Discounted cash flow analysis has its drawbacks. Here are the key limitations:

• Highly sensitive to assumptions: Small changes in assumptions can drastically affect results.
• Complex and subjective: The calculations are complex and rely on subjective inputs, making accuracy challenging.
• Data-heavy and market-limited: It requires reliable data and overlooks current market trends, focusing more on projected cash flows.

What are the Steps in the Discounted Cash Flow Analysis in Excel?

Have you ever felt like crunching numbers in Excel is like finding your way through a maze? Discounted Cash Flow (DCF) analysis data visualization can help you navigate the twists and turns.

Visualizations play a crucial role in data analysis, transforming raw numbers into meaningful insights. They make complex data easier to understand and help uncover trends and patterns.

However, Excel’s basic chart options often fail to deliver clear, impactful visuals. When working with Discounted Cash Flow (DCF) analysis or creating a cash flow chart, this limitation can hinder your ability to convey financial insights effectively.

That’s where ChartExpo steps in. It offers advanced data visualization tools to overcome Excel’s limitations and bring your DCF analysis to life.

Top 5 Charts

Clustered Column Chart

Waterfall Chart

Column Chart

Multi Series Line Chart

Multi Axis Line Chart

Let’s learn how to install ChartExpo in Excel.

1. Open your Excel application.
2. Open the worksheet and click the “Insert” menu.
3. You’ll see the “My Apps” option.
4. In the Office Add-ins window, click “Store” and search for ChartExpo on my Apps Store.
5. Click the “Add” button to install ChartExpo in your Excel.

ChartExpo charts are available both in Google Sheets and Microsoft Excel. Please use the following CTAs to install the tool of your choice and create beautiful visualizations with a few clicks in your favorite tool.

Example

Let’s use the sample data below to do a Discounted Cash Flow analysis in Excel with ChartExpo.

Period	Cash Flow (in thousand USD)	Discount Rate	Discount Factor	Discounted Cash Flow
Y-2019	145	6.77	0.288	42
Y-2020	138	6.77	0.27	37
Y-2021	131	6.77	0.253	33
Y-2022	102	6.77	0.237	24
Y-2023	112	6.77	0.171	19

• To get started with ChartExpo, install ChartExpo in Excel.
• Now Click on My Apps from the INSERT menu.

• Choose ChartExpo from My Apps, then click Insert.

• Once it loads, scroll through the charts list to locate and choose the “Multi Axis Line Chart”.

• Click the “Create Chart From Selection” button after selecting the data from the sheet, as shown.

• ChartExpo will generate the visualization below for you.

• Click on Settings and change the “Data Representation” as follows.

• If you want to add anything to the chart, click the Edit Chart button:

• Click the pencil icon next to the Chart Header to change the title.
• It will open the properties dialog. Under the Text section, you can add a heading in Line 1 and enable Show.
• Give the appropriate title of your chart and click the Apply button.

• You can add the dollar sign with discounted cash flow value as follows:

• You can add the percentage sign with “Discounted Rate” values as follows:

• You can add the dollar sign with “Cash Flow” values as follows:

• First, you can enable the Legend Show button as follows:

• Change the Legend shape of “Discounted Cash Flow” to Column and click the “Apply” button.

• Change the Legend shape of “Discount Rate” into a Line and Circle and click the “Apply” button.

• Change the Legend shape of “Discount Factor” into a Line and Circle and click the “Apply” button.

• Click the “Save Changes” button to persist the changes made to the chart.

• Your final Multi Axis Line Chart will look like the one below.

Insights

• 2019-2021: Cash flows decline
• 2022-2023: Slight recovery in cash flows
• Discounted Cash Flows: Steady decrease due to a 6.77% discount rate, showing time value erosion

FAQs

What does a discounted cash flow analysis tell you?

A discounted cash flow analysis estimates the present value of future cash flows. It helps determine if an investment is undervalued or overvalued. By considering the time value of money, it reveals the potential profitability of the investment.

How to interpret DCF analysis?

Interpret DCF analysis by comparing the calculated present value to the investment’s current price. If the present value is higher, the investment may be undervalued. If it’s lower, the investment could be overvalued. This guides investment decisions.

What is the most important factor in DCF?

The most important factor in DCF is the discount rate. It reflects the risk and opportunity cost of the investment. A higher rate lowers the present value, while a lower rate increases it, directly impacting the analysis outcome.

Wrap Up

Discounted cash flow (DCF) analysis is a powerful financial tool. It helps investors and businesses assess the value of an investment based on future cash flows. By adjusting these cash flows to their present value, you can see if an opportunity is worth pursuing.

The core idea is simple. Money now is worth more than money later. DCF captures this by using a discount rate to reflect the time value of money and risk.

This analysis isn’t only useful for big corporations. Small businesses and individual investors can also benefit from DCF. It provides clarity on whether to move forward with an investment or not.

DCF’s flexibility allows you to adjust for different scenarios. You can tweak variables like growth rates and discount rates to suit the situation.

While the method involves some calculations, its insight is worth it. It gives a clear picture of an investment’s potential profitability. DCF analysis equips you with the information needed to make those informed decisions confidently.

Do not hesitate.

Start using DCF analysis with ChartExpo today and understand the true value of your investments.