What is DCF?
Tk 100 today and Tk 100 a year from now are not equal. Today’s money can be put in an FDR or savings certificate and grow by the end of the year, and there is always some doubt whether future money will arrive at all. This is the time value of money.
DCF applies this idea to a business. Each future year’s cash flow is divided down by a rate (the discount rate) to bring it to today’s value, and then everything is added up. The total is one estimate of the business’s intrinsic value.
Say a relative offers you Tk 1,00,000 today, or Tk 1,10,000 exactly one year from now. If you can surely earn 10% a year, the two are about equal: 1,10,000 ÷ 1.10 = 1,00,000. But if you doubt the later money will come, you will prefer the cash today. Shrinking later money like this to its value today is discounting. The numbers are only an example.
Why it matters to an investor
- It puts assumptions in the open: growth, risk and how many years all have to be written down, so you can see where the weak points are.
- It explains why share prices come under pressure when interest rates rise: a higher discount rate lowers today’s value of future money.
- It shows why promises far in the future are worth less: money 20 years away is worth much less today.
- It lets you check, in reverse, what the market price assumes: how fast would the company have to grow for this price to make sense?
The four steps
- 1. Estimate free cash flow: the cash left for owners after costs and the new investment the business needs. The CFA Institute warns against treating net profit or EBITDA directly as cash flow.
- 2. Choose a discount rate: the annual return you require for this level of risk. It is usually a near risk-free rate, such as on government bonds, plus an extra amount for risk.
- 3. Terminal value: the value of all the years after the detailed forecast, usually with a steady-growth formula: next year’s cash flow ÷ (discount rate − growth rate).
- 4. Bring everything to today’s value and add it up. If you worked with the whole company’s cash flow, subtract debt at the end and divide by the number of shares.
“Garbage in, garbage out”
A DCF answer is only as good as its assumptions. A change of one or two percentage points in the discount rate or growth rate can move the value a long way. And in most cases a large share of the total comes from the terminal value, meaning the most distant and most uncertain years.
So experienced analysts build not one number but a few scenarios (pessimistic, middle, optimistic) and look at the range. The growth rate can never be set equal to or above the discount rate; if it is, the formula stops making sense.
Worked example
- Say an imaginary company, “Rupsha Foods Limited”, will have free cash flow of Tk 5 per share in each of the next three years. Discount rate: 12%.
- Value today: 5 ÷ 1.12 = 4.46; 5 ÷ 1.12² = 3.99; 5 ÷ 1.12³ = 3.56. Total for three years ≈ Tk 12.01.
- If cash flow then grows 4% a year for good, terminal value = (5 × 1.04) ÷ (0.12 − 0.04) = Tk 65. In today’s money: 65 ÷ 1.12³ ≈ Tk 46.27.
- Total value ≈ 12.01 + 46.27 = Tk 58.28, of which about 79% comes from the terminal value.
- Now change one assumption at a time: at a 14% discount rate the value is ≈ Tk 46.71; keeping 12% but with 6% growth, ≈ Tk 74.88.
Result: two small changes in assumptions moved the value between about Tk 47 and Tk 75. DCF is excellent for organising your thinking, but treat its answer as a range. The numbers are only an example.
See the numbers as a table
| First three years’ cash flow | Terminal value | |
|---|---|---|
| In today’s money | 12 | 46 |
Common mistakes
- Thinking the answer is precise because it is worked out to two decimal places.
- Treating net profit as cash flow without taking out the investment the business needs.
- Assuming very high growth for year after year, or pushing the growth rate close to the discount rate.
- Starting with the answer you want and arranging the assumptions to fit.
DCF means bringing every future taka back to today and adding it up. The formula is simple; the quality of the answer depends entirely on the honesty of your assumptions.