Every good business manager needs to have proven methods for how he runs his business successfully. These methods could include things like planning for supply chain management, dealing with logistics, and forecasting future sales and growth. However, one of the most important financial practices that a business manager should implement is often overlooked. It is a formula for judging the value of future revenue. That formula is called the discounted cash flow.
In this article we are going to look at what discounted cash flow is and how to measure it. You can also read on how measuring it and using it for evaluating capital expenditure projects can help push a business to greater levels of success. Also, we will look at how the DCF model can be a useful tool for investors. You will read also why college professors should be teaching this model to their students.
What Is the Discounted Cash Flow?
Discounted Cash Flow (DCF for short) is a financial formula that measures the value of future investment returns based on prevailing interest rates. The basic premise of the DCF model is that the value of a dollar today is worth more than the value of a dollar tomorrow due to inflation. Therefore, the value of free cash flows (FCF) from an investment in future years must be discounted back to today to determine its true worth.
It is calculated like this:
FCF (at Year 1)/(1 + inflation rate^1 [or WACC]) + FCF (at year 2)/(1+inflation rate^2) + …
Who Needs to Use Discounted Cash Flow the Most
Typically, companies that need to use the DCF model the most for valuing future cash flows are companies that have a high level of fixed investment in property, plant, and equipment (PP&E). These companies need to know before they build a new facility if the facility will generate sufficient cash flows. This is because, when discounted back to the current time, those cash flows are generating returns that meet company objectives.
As a result, manufacturing companies are most likely to use the DCF model for valuing free cash flows.
How Much Is Usually Spent on Evaluating Discounted Cash Flow?
Usually, a company that employs the DCF model will hire a single financial analyst or a team of financial analysts. They run the calculations that are necessary and evaluate which pre-supposed variables the company is going to use in the equations. While this may seem like a simple process, it is actually highly complex. As a result, these analysts can often command a salary of $80-$100,000.
This means that the total cost of implementing the DCF model could reasonably cost a company as much as $1 million per year.
How the Discounted Cash Flow Can Help Your Company Succeed
1. DCF Easily Eliminates Certain Capital Expenditure Decisions
It is so critically important that a business only spends money on projects that are going to generate solid, positive cash flow. While, on its face, it may seem like certain projects will do exactly that, the DCF model helps to quickly eliminate projects that are actually only positive when addressed in nominal dollar terms. This helps to save the company time when searching for the next best project. Obviously, this translates into money saved and pitfalls avoided.
2. DCF Allows More Accurate All-In Projections
Let’s assume that a company thinks that it may make $10 million from a future project over five years. But it knows that it will only be able to make $2 million for sure. Then, the DCF model will help the company better estimate its future discounted free cash flows.
Using the DCF model, an analyst for the company could generate best-case, worst-case, and average scenarios. Then, the analyst averages those scenarios into one projected future free cash flow based on the probabilities of each scenario. Thereby, they are giving the company a more accurate forecast.
3. It Is Incredibly Useful for Stock Valuation
Now, let’s take the cases where a company pays a dividend on its common stock. Then, an average investor can use the DCF model to generate a fairly accurate view of what the stock’s price should be. This is possible based on future expected dividends paid out. This makes the DCF model probably the single-most important stock valuation tool for investors to use in the case where a stock pays a dividend.
Of course, even this use of the model is based on some weighty assumptions. But an investor can generally get a fairly accurate view of what the future dividends from a company will be. He is able to estimate this by the prior performance and a company’s growth rate(s).
4. It Can Help Young Students Understand the Value of Investing
While seemingly amiss in this article, it is important to note that teaching the DCF model to collegiate students is critical. This is because it helps young adults understand the value of investing in their future early.
What the DCF model shows us is that future dollars aren’t worth as much as today’s dollars due to inflation. So it is critical that we begin investing with today’s dollars as soon as possible if we want more of tomorrow’s pleasures.
Putting It All Together
Discounted Cash Flow modeling is an incredibly useful tool to be employed by businesses and investors alike. Furthermore, as we have seen, it can be a good teaching method for showing students (if they can grasp the concept) that investing from an early age is critically important.
If you have never used the DCF model in your own purposes, now you see that it is such a useful tool that pretty much every person should be employing it in one way or another.
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