Dcf Calculation Formula

Discounted Cash Flow (DCF) Calculator

Understanding the Discounted Cash Flow (DCF) Valuation Method

The Discounted Cash Flow (DCF) method is a widely used valuation technique that estimates the value of an investment based on its expected future cash flows. The core principle behind DCF is that an asset is worth the sum of all its future cash flows, discounted back to their present value. This approach is fundamental in finance for valuing companies, projects, or even individual assets.

How the DCF Calculator Works

Our DCF calculator helps you estimate the intrinsic value of a business or project by following these steps:

1. Initial Free Cash Flow ($): This is the starting point – the Free Cash Flow (FCF) generated by the business in the most recent period (e.g., the current year). FCF represents the cash a company generates after accounting for cash outflows to support its operations and maintain its capital assets.
2. Forecast Period Growth Rate (%): This is the expected annual growth rate of the Free Cash Flow during a specific explicit forecast period. This period typically ranges from 5 to 10 years, during which a company's growth can be reasonably predicted.
3. Forecast Period (Years): The number of years for which you explicitly forecast the Free Cash Flows.
4. Discount Rate (WACC) (%): The discount rate is crucial. It represents the rate of return required by investors, reflecting the riskiness of the cash flows. For companies, this is often the Weighted Average Cost of Capital (WACC), which accounts for the cost of both equity and debt. Higher risk typically means a higher discount rate.
5. Perpetual Growth Rate (%): After the explicit forecast period, it's assumed that the company's cash flows will grow at a constant, sustainable rate into perpetuity. This rate is usually low, often aligning with the long-term inflation rate or GDP growth rate, as companies cannot grow at high rates indefinitely.

The DCF Calculation Process

The calculator performs the following calculations:

1. Projecting Free Cash Flows: It first projects the Free Cash Flows for each year of the explicit forecast period, applying the specified forecast period growth rate to the initial FCF.
2. Discounting Forecasted Cash Flows: Each projected FCF is then discounted back to its present value using the discount rate. The sum of these present values gives you the "Sum of Present Value of Forecasted Cash Flows."
3. Calculating Terminal Value: At the end of the forecast period, a "Terminal Value" is calculated. This represents the value of all cash flows beyond the explicit forecast period, growing at the perpetual growth rate. The Gordon Growth Model is commonly used for this: TV = FCF_n * (1 + g) / (r - g), where FCF_n is the last forecasted FCF, g is the perpetual growth rate, and r is the discount rate.
4. Discounting Terminal Value: The Terminal Value is then discounted back to its present value to reflect its worth today.
5. Total DCF: Finally, the "Sum of Present Value of Forecasted Cash Flows" and the "Present Value of Terminal Value" are added together to arrive at the "Total Discounted Cash Flow (DCF)," which is the estimated intrinsic value of the asset.

Interpreting the Results

The "Total Discounted Cash Flow (DCF)" represents the estimated intrinsic value of the company or project based on your inputs. If this intrinsic value is higher than the current market price of the asset (e.g., a company's market capitalization), it might suggest that the asset is undervalued. Conversely, if the DCF value is lower, it could indicate overvaluation.

Important Considerations and Limitations

• Sensitivity to Inputs: DCF is highly sensitive to its inputs, especially the discount rate and growth rates. Small changes can lead to significant differences in the final valuation.
• Assumptions: The model relies heavily on future assumptions, which are inherently uncertain. The accuracy of the DCF valuation depends on the realism of these assumptions.
• Perpetual Growth Rate: The assumption of perpetual growth can be challenging. It must be less than the discount rate, and typically should not exceed the long-term economic growth rate.
• Free Cash Flow Definition: Ensure consistency in how Free Cash Flow is defined and calculated.

Example Calculation:

Let's use the default values in the calculator:

• Initial Free Cash Flow (FCF0): $100,000
• Forecast Period Growth Rate: 5% (0.05)
• Forecast Period: 5 Years
• Discount Rate (WACC): 10% (0.10)
• Perpetual Growth Rate: 2% (0.02)

Step 1: Project Free Cash Flows and their Present Values

• Year 1 FCF = $100,000 * (1 + 0.05) = $105,000
• PV Year 1 FCF = $105,000 / (1 + 0.10)^1 = $95,454.55
• Year 2 FCF = $105,000 * (1 + 0.05) = $110,250
• PV Year 2 FCF = $110,250 / (1 + 0.10)^2 = $91,115.70
• Year 3 FCF = $110,250 * (1 + 0.05) = $115,762.50
• PV Year 3 FCF = $115,762.50 / (1 + 0.10)^3 = $86,970.08
• Year 4 FCF = $115,762.50 * (1 + 0.05) = $121,550.63
• PV Year 4 FCF = $121,550.63 / (1 + 0.10)^4 = $82,989.00
• Year 5 FCF = $121,550.63 * (1 + 0.05) = $127,628.16
• PV Year 5 FCF = $127,628.16 / (1 + 0.10)^5 = $79,099.00

Sum of PV of Forecasted Cash Flows = $95,454.55 + $91,115.70 + $86,970.08 + $82,989.00 + $79,099.00 = $435,628.33

Step 2: Calculate Terminal Value (TV)

• FCF at end of Forecast (Year 5) = $127,628.16
• Next Year's FCF (Year 6) = $127,628.16 * (1 + 0.02) = $130,180.72
• Terminal Value (TV) = $130,180.72 / (0.10 – 0.02) = $130,180.72 / 0.08 = $1,627,259.00

Step 3: Calculate Present Value of Terminal Value (PV_TV)

• PV_TV = $1,627,259.00 / (1 + 0.10)^5 = $1,627,259.00 / 1.61051 = $1,010,399.00

Step 4: Total DCF

• Total DCF = Sum of PV of Forecasted Cash Flows + PV of Terminal Value
• Total DCF = $435,628.33 + $1,010,399.00 = $1,446,027.33

This example demonstrates how the calculator arrives at the intrinsic value, providing a clear understanding of each component's contribution.