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Discounted cash flow
Practical Law ANZ Glossary w-013-7721 (Approx. 3 pages)
Glossary
Discounted cash flow
Also known as the DCF method. A valuation method used to estimate the returns an investor (for example, a private equity buyer) would receive from an investment, adjusted for the time value of money (a principle that recognises that an amount of money received today is worth more than the same amount if it is received in the future due to various factors including inflation and the opportunity cost of making the investment as compared to alternative investments).
Under the DCF method, future cash flows are estimated and then discounted by a specified rate (the discount rate) that takes into account the time value of money and the uncertainty of future cash flows to give a single figure that represents the net present value (NPV) of the investment's future cash flows.
There is no single agreed method of calculating the discount rate. Popular methods include:
- The "build-up procedure", which adds together different components of risk facing the company at a specific time and then compiles these into an overall discount rate.
- The "weighted average cost of capital procedure" (WACC procedure), which estimates the future cost to the company of borrowing new debt and the cost to the company of obtaining new equity capital. This is then weighted to determine an overall cost of capital to the company, which is usually expressed as a percentage. It is this percentage that is then determined to be the discount rate.
The advantages of the DCF method include that it:
- Can be used by investors to determine whether or not to undertake a project or to invest in a business.
- Is a widely used and accepted basis for calculating damages in international arbitration.
- Is considered to be a flexible accounting tool and can be used in a variety of situations.
- Is seen as a reliable means to measure value in situations where it may be difficult to find sales of comparable properties or assets (for example, oil and gas properties).
- Can be used where the value of future project revenues is uncertain.
The disadvantages of the DCF method are:
- If the business in question is a start-up or new business, there may be insufficient evidence of the business's current profits to provide a reliable estimate of its likely future profits.
- Its reliability depends on the data used in the calculations.
- There are several different methodologies that can be employed in the DCF method. Depending on the methodology used, the resulting NPV may vary hugely.