Have you ever asked yourself how you can judge whether a future investment will bring profit or loss? Enter the world of discounted cash flow (DCF), an analysis method that helps you make informed financial decisions by analyzing the future value of your investments today.
In this article, you will learn what DCF means, what the calculation formula is and how to interpret the results. At the end, you will also learn a practical example of the DCF method in action and why it is so important for modern business owners and financial experts.
What is the discounted cash flow?
Discounted cash flow (DCF) is a valuation method used to estimate the attractiveness of an investment based on its future cash flows. This analysis converts future projections into present value so that you can assess whether an investment is worthwhile.
In Bahasa Indonesia, DCF is often referred to as arus kas diskonto or arus kas terdiskonto. According to the Indonesian Financial Services Authority (Otoritas Jasa Keuangan or OJK), the DCF represents the expected value of future cash inflows or outflows, adjusted for the time value of money and associated risks. But why do you as a business owner need to assess your investment using the DCF?
You need to understand that money today has a higher value than the same amount in the future due to factors such as inflation and opportunity costs. The DCF method allows you to calculate potential gains or losses from investments by taking these changes over time into account.
Businesses often rely on the DCF method when making investment and budget decisions, for example when acquiring assets, starting new projects or buying shares. It is a cornerstone of a sound financial strategy.
Why DCF is important for businesses
Using DCF analysis offers a range of advantages for finance professionals and business owners:
Objective cash flow valuation
DCF provides a clear and unbiased valuation by converting future cash flow projections into present value. This structured approach provides a detailed insight into the intrinsic value of an investment and allows you to make decisions based on concrete data.
Takes into account the time value of money
One of the outstanding features of DCF is the consideration of the principle that today's Rp1 does not correspond to Rp1 in the future. Since future money usually has a lower real value, understanding this concept is crucial for the valuation of long-term investments.
DCF allows you to assess how time will affect your future cash flows, giving you a comprehensive analysis of potential outcomes.
Risk assessment for smarter decisions
DCF also allows you to consider investment risks via the discount rate. This allows you to compare different investment options and select those that best align with your business objectives while understanding the potential risks involved.
How to calculate the discounted cash flow
The concept of the DCF formula is simple: all you have to do is divide the projected cash flow by the discount rate. However, as simple as it may sound, the DCF calculation can be somewhat complex as it aims to provide you with the present value of the projected cash flow of an investment.
Below you will find the detailed formula of the DCF
Here you can find out what the individual variables mean:
CF₁, CF₂, CFₙ: Cash flow for year 1, 2 and the following years
r: Discount rate
n: Year
To evaluate the DCF for a specific period, enter the projected cash flows and the selected discount rate. For example, for a DCF calculation for five years, you need to add the cash flows and apply the formula for each year.
DCF = CF1(1+ r)1+CF2(1+ r)2+CF3(1+ r)3+CF4(1+ r)4+CF5(1+ r)5
Once you have calculated the DCF, subtract the initial investment to determine whether the project or investment is likely to generate positive returns:
Present value of projected profit = DCF - initial investment
Interpreting DCF results
Once you have calculated the DCF, you will arrive at one of three scenarios:
- Positive DCF: The future cash flows exceed the initial investment. This indicates profitability and makes the investment worth pursuing.
- Negative DCF: The future cash flows are less than the initial investment, indicating possible losses.
- Zero DCF: The future cash flows are equal to the initial investment, meaning no profit or loss.
How to calculate the discounted cash flow
Follow these steps to calculate the discounted cash flow:
- Calculate free cash flow, including cash inflows and outflows, changes in capital and net investment.
- Project the cash flows based on growth rates for future years.
- Determine the discount rate by adjusting the weighted average cost of capital (WACC) based on expected profitability. Typically, discount rates range from 10%-15% for established companies and 25%-50% for startups.
- Specify the desired calculation period (such as five years).
- Enter the figures into the formula to obtain the DCF result.
DCF example in the real world
Let’s illustrate this concept with an example.
XYZ Energy plans to invest Rp1.2 billion in a micro-hydropower project. The project is expected to generate free cash flows of Rp500 million in the first year, with an annual growth rate of 5%. The company wants to know how much return it will get from this investment based on DCF analysis.
As a first step, the company calculates the projected cash flow for the next five years by taking into account the cash flow in the first year and the annual growth rate.
- Year 1: Rp500,000,000
- Year 2: Rp500.000.000 + (Rp500.000.000 x 5%) = Rp525.000.000
- Year 3: Rp525.000.000 + (Rp525.000.000 x 5%) = Rp551.250.000
- Year 4: Rp551.250.000 + (Rp551.250.000 x 5%) = Rp578.812.500
- Year 5: Rp578.812.500 + (Rp578.812.500 x 5%) = Rp607.753.125
Once the company has determined the projected cash flow for the next five years, it can calculate the present value of those projected cash flows. In this case, the company uses a discount rate of 15% in the calculation.
DCF = CF1(1+ r)1+CF2(1+ r)2+CF3(1+ r)3+CF4(1+ r)4+CF5(1+ r)5
DCF = 500.000.000(1+ 0,15)1+525.000.000(1+ 0,15)2+551.250.000(1+ 0,15)3+578.812.500(1+ 0,15)4+607.753.125(1+ 0,15)5
DCF = 500.000.0001,15+525.000.0001,3225+551.250.0001,520875 +578.812.5001,749006 +607.753.1252,01135
DCF =434.782.609+396.975.425+362.455.823+ 330.937.972+302.161.794
DCF =1.827.313.623
From the above calculation, it can be concluded that the project will generate a free cash flow of Rp1.83 billion based on present value. But is the project profitable for the company?
Present value of projected profit = DCF - initial investment
Present value of projected profit = Rp1,827,313,623 - Rp1,200,000,000
Present value of projected profit = Rp627,313,623
The final result shows that the DCF for XYZ Company’s power plant project is positive and amounts to Rp627.31 million. Thus, the project is deemed profitable and feasible for the company.
However, the company must also realize that the final result is only an estimate. Therefore, it should consider other risk factors before making a final decision.
Advantages and disadvantages of DCF
DCF can be the ideal tool for businesses to measure the feasibility of a project. However, like other financial methods, DCF has its own advantages and limitations.
Advantages of DCF:
- Helps determine whether an investment is profitable.
- Covers critical aspects such as profit margins, costs and risks.
- Flexible enough to adapt to different scenarios.
- Useful for calculating the internal rate of return (IRR).
Disadvantages of DCF:
- Results are estimates, not actual figures.
- External factors such as market demand and technological changes can interfere with projections.
- Requires multiple assumptions, and errors in any one assumption can distort the results.
- Does not take into account competitive factors or external influences.
Effective cash flow management with Aspire
An accurate DCF analysis starts with excellent cash flow management. Aspire, an all-in-one financial platform, enables businesses to manage their finances efficiently and eliminates the need for manual, error-prone methods.
With Aspire you can:
- Use multi-currency business accounts to make local transfers in foreign currencies.
- Automate disbursement with API integrations.
- Simplify payments from more than 26 payment methods with Aspire's payment gateway.
- Empower your team with Aspire corporate cards.
- Integrate Aspire with accounting software to expedite bookkeeping and financial reporting.
Ready to take your cash flow management to the next level? Get in touch with Aspire today and start maximizing your business potential!
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