Today we are looking at how the Discounted Cash Flow (DCF) method is used to evaluate investment opportunities or project alternatives in big companies, like launching a new product, a new assembly line, etc.
We can use the DCF method whenever we consider paying now to get more money (or benefits) later.
Investors and Investment banking analysts use DCF to determine the price of a business when deciding on investment opportunities.
The underlying principle is that an investment is currently worth as much as its expected future cash flows, adjusted for the time value of money, or discounted to the present value.
Discounted Cash Flows
Let us look at the DCF formula:
- CF is the cash flow for each consecutive period
- r is the discount rate (big companies often use WACC)
The Discounted Cash Flows method translates the expected future cash flows that we will likely receive into their present value, based on the compounded rate of return that we can reasonably achieve today.
If an investment’s price is below its DCF, then it may be undervalued, and potentially very lucrative. And if the price is higher than the DCF, it’s a strong sign that the investment may be overvalued.
Compare investment alternatives
Let us look at two investment alternatives and use the DCF method to select in which to invest. For this exercise, we assume that we have an investment budget of 500,000 euros and our desired return on investment is 9%.
Our first investment opportunity is to buy a land plot in an underdeveloped area for 500,000 euros that we can then sell in 10 years for 1,300,000 euros. And the alternative is to invest in a private equity fund which will give us an 11% return for the next ten years, plus return our initial investment at the end of the ten years.
If we look at the cash flows, we can easily calculate that the first option will give us an 800,000 euro profit, and the alternative will give us 550,000 euro profit (11% * 500,000 euros * 10 years), so it appears that we should invest in the land plot. Here’s where DCF comes in.
To help our choice, we can build a simple DCF model in Excel.
After calculating the DCF of both investment alternatives, we can see that the second alternative is better. When we factor in the time value of money, it turns out that the different distribution over the ten years makes the land plot less desirable, even if the gross amount of returns over the years is more than the profits from the investment fund alternative.
Many companies use their WACC (Weighted Average Cost of Capital – the average cost the company pays for capital from borrowing or selling equity) as a discount rate when applying the DCF method to evaluate different projects.
Let us look at two different project ideas within a company and decide on where to invest.
The company has a Weighted Average Cost of Capital of 10%. Currently, the company has a budget of 400,000 euros to improve costs related to the production line. One will decrease external repair services with 40,000 euros for the first two years and with 80,000 euros for the next eight years. The alternative project will reduce the cost of the overall biannual full maintenance of the assembly line by 135,000 euros. We need to figure out where should the company invest, considering which project will provide more future benefits in the form of cost reductions.
To figure that out let’s use our previous model to calculate the DCF for the two alternative projects.
Looking at the DCF of both projects, we see that considering the time value of money, the project that decreases the maintenance costs is worth more to invest in than the alternative, which will have a near-zero negative effect from the investment over time. Therefore it will be better for the company to go with the project that will decrease the external servicing costs for repairs, which will give around 20 thousand more benefits in the form of cost reductions, over the initial investment.
Discounted Cash Flows Limitations
The issue with using the Discounted Cash Flows method is not with building the model itself. The math is straightforward, and the technique is easy to implement. The problem is predicting the future and estimating the cash flows. If we are wrong about the cash flows that we will receive, then the DCF model won’t be beneficial for us – it will be either over- or underestimated.
The DCF analysis is a powerful method to estimate the fair value of any investment or project that is expected to generate cash flows. Almost every other valuation method builds on the DCF in one way or another.
However, estimating future cash flows is not merely math; it’s a form of art. And since we can’t see into the future (at least I can’t), best we can do is break down the future cash flows to smaller pieces and hope our estimations for those pieces are reasonable enough.
That was a brief look into Discounted Cash Flows. You can download the excel working below.
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