Question

Discounted cash flow is commonly used in business valuation.

What data is necessary for DCF? How is that data used?

How can you validate the data? What are the limitations of DCF analysis?

Please supply your perspective on any or all of these questions.

Answer 1

Periods of time.

The projected cash flow that will occur every year.

A discount rate or annual rate. The discount rate could be thought of as how much money you’d earn if you invested it in another account with equal risk.

The terminal value. This number represents the perpetual growth rate for future years outside of the timeframe being used

Calculation of discounted cash flow :
The Discounted Cash Flow calculation formula can be as simple or complex as we want. To get started, use this formula:

(Cash flow for the first year / (1+r)¹)+(Cash flow for the second year / (1+r)²)+(Cash flow for N year / (1+r)^N)+(Cash flow for final year / (1+r)

In the formula, cash flow is the amount of money coming in and out of the company. For a bond, the cash flow would consist of the interest and principal payments.

R represents the discount rate, which can be a simple percentage, such as the interest rate, or it’s common to use the weighted average cost of capital. The discount rate represents the required rate of return for investors to receive the money they’re receiving. For a bond, a discount rate would be the interest rate.

The weighted average cost of capital is the rate a company pays to finance its assets. It includes the average cost of a company’s working capital after taxes. This can include common and preferred stock, bonds, or long-term debt.

N represents the period of time. A business owner can use as many cash projections as they want for the Discounted Cash Flow analysis – it can be five years, 10 years, or even longer.

The final calculation at the end of the formula is considered the terminal value. This represents the growth rate for projected cash flows for the years outside of the timeframe you’re using.

To find the terminal value, take the cash flow of the final year, multiply it by (1+ long-term growth rate in decimal form) and divide it by the discount rate minus the long-term growth rate in decimal form.

Limitations of DCF :

The Discounted Cash Flow model can be a very helpful tool for those working in the financial industry, as well as the small business owner. But there are limitations with the model to consider.

It’s important to try to be realistic when making predictions. It’s possible for projections of future cash flow to be inflated when doing a Discounted Cash Flow analysis. The Discounted Cash Flow analysis relies on the information plugged into it, so the end result is dependent on what numbers are used in the formula. It’s also important to note that if you miscalculate your projected cash flows or a part of the Discounted Cash Flow formula, you won’t get an accurate result.

Generally, the numbers used for a Discounted Cash Flow analysis aren’t based on actual data. The cash flow amounts are projections and you have to predict the growth rate of the company you’re trying to find the value of. Although you can predict what next year’s cash flow would be by using the current and previous year’s data, projections farther in the future are assumed. It’s hard, if not impossible, to predict how a business is actually going to perform in the future and how it will be impacted by the market. And even if the company does experience growth in the future, it could be higher—or lower— than the rate used in the Discounted Cash Flow analysis.

The terminal rate, or the percentage used in the Discounted Cash Flow formula to represent growth for all future years of the company’s existence, is usually 3%. That’s because it represents the growth rate in the U.S. But the terminal rate shouldn’t be 3% for some companies because the economy grows when new companies startup. For a company that has been in business for a long time, 3% could be too high of a rate. If that’s the case, the Discounted Cash Flow analysis gives a valuation that’s higher than what the company may actually be worth.

The terminal rate or terminal value also accounts for a large portion of the estimated value from the Discounted Cash Flow analysis. Changing the terminal rate slightly could result in large fluctuations with the result you’d get from the analysis. So, it’s important to make sure you’re using the most accurate data for the calculation.

The limitations with the terminal rate apply to the overall growth rate for the timeframe being used in the Discounted Cash Flow. The assumption is the company will experience growth at a certain percentage the longer the company is in business. But the growth rate chosen to be used in the analysis is a prediction.

As with any valuation model, it’s important to keep things up to date. With the Discounted Cash Flow formula requiring numerous elements, analysts may not place as much of an emphasis on focusing on any outside factors that can impact the company, such as competition. If you’re only using the Discounted Cash Flow regularly, consider going back to your analysis in the future and comparing it to the actual cost and figures. By doing this, you can see how accurate you were with your projections and if there’s a certain area of the formula you should work on for future asset investments.

Although the Discounted Cash Flow analysis is commonly used, it’s important to understand its limitations. The calculation is only as good as the information put into it. Because the method is based heavily on projections and assumptions of a company’s performance in the future, the Discounted Cash Flow analysis can be used in parallel with other valuation models to provide a more accurate picture.