Discounted Cash Flow (DCF) (2024)

FAQs

Should I do a 5 year or 10 year DCF? ›

If the life of the project is 5 years then you should use the 5 year rate. If the project you are evaluating extends beyond 5 years, and you will be using a perpetual rate during the last year, then you can use the 10 year rate.

The main Cons of a DCF model are:

Prone to errors. Prone to overcomplexity. Very sensitive to changes in assumptions. A high level of detail may result in overconfidence.

DCF Valuation is extremely sensitive to assumptions related to perpetual growth rate and discount rate. Any minor tweaking here and there, and the DCF Valuation will fluctuate wildly and the fair value so generated won't be accurate. It works best only when there is a high degree of confidence about future cash flows.

If the DCF value calculated is higher than the current cost of the investment, the opportunity should be considered. If the calculated value is lower than the cost, then it may not be a good opportunity, or more research and analysis may be needed before moving forward with it.

The 3-statement models that support a DCF are usually annual models that forecast about 5-10 years into the future. However, when valuing businesses, we usually assume they are a going concern.

We discuss four factors you should consider when determining how many years you forecast your cash flows in detail in this article. The default value in business school is 5 years cash flow forecast for DCF valuation. However, there will be times when a three-year cash flow forecast may be more appropriate.

Also, since the very focus of DCF analysis is long-term growth, it is not an appropriate tool for evaluating short-term profit potential. Besides, as an investor, it's wise to avoid being too reliant on one method over another when assessing the value of stocks.

The first mistake seen in DCF models is accidentally including the latest historical period as part of the Stage 1 cash flows. The initial forecast period should consist of only projected free cash flows (FCFs) and never any historical cash flows. The DCF is based on projected cash flows, not historical cash flows.

No, DCF analysis is not the hardest analysis in finance. While it can be complicated, there are other financial analyses that can be even more challenging. DCF stands for Discounted Cash Flow and is basically a way of valuing a company or asset based on its expected future cash flows.

The reliance on assumptions is the main drawback of the DCF approach, in which minor adjustments to key assumptions could have material impacts on the DCF valuation.

Do investment bankers use DCF models? ›

Discounted cash flow (DCF) analysis is one of the most widely used methods of valuing companies or projects in investment banking (IB). It involves projecting the future cash flows of the target and discounting them back to the present value using an appropriate discount rate.

Understanding DCF Analysis

The DCF is often compared with the initial investment. If the DCF is greater than the present cost, the investment is profitable. The higher the DCF, the greater return the investment generates. If the DCF is lower than the present cost, investors should rather hold the cash.

DCF helps gauge the current worth of future cash flows, while NPV provides a holistic view by factoring in initial investment costs, helping investors make informed decisions based on both projected earnings and upfront expenses.

The Discounted Cash Flow method can often give us a much better measure of a project's profitability, for three main reasons: DCF washes out year-to-year variations in profit and gives us a single valid figure for the whole life of the project.

Levered DCF: The levered DCF approach calculates the equity value directly, unlike the unlevered DCF, which arrives at the enterprise value (and requires adjustments thereafter to arrive at equity value). Unlevered DCF: The unlevered DCF discounts the unlevered FCFs to arrive at the enterprise value (TEV).

The long-term growth rate should theoretically be the growth rate that the company can sustain into perpetuity. Often, GDP growth or the risk-free rate can serve as proxies for the growth rate.

Also, since the very focus of DCF analysis is long-term growth, it is not an appropriate tool for evaluating short-term profit potential. Besides, as an investor, it's wise to avoid being too reliant on one method over another when assessing the value of stocks.

An Unlevered DCF is easier to set up and produces more consistent results that depend far less on a company's capital structure. There are a few specialized cases where a Levered DCF might be helpful (e.g., with Equity REITs), but 99% of the time, the Unlevered DCF is superior.