Discounted cash flow (DCF) method is the most popular valuation method currently used for effective investment decision making. By calculating the present value of the expected future cash flows, in discounted cash flow (DCF) valuation method the value of an asset is the present value of the expected cash flows discounted by the cost of risk incurred by the cash flows and the life of the asset.
Discounted cash flow (DCF) valuation is based on two fundamental principles:
- Every asset has an intrinsic value that can be projected if cash flows, growth and risk are known.
- Markets are inefficient and assets are not priced perfectly.
These two key principles drive the DCF valuation method in terms of forecasting the expected cash flows, the life of the asset and the discount rate that applies on these cash flows to calculate their present value. Put simply, when using DCF valuation method, analysts aim at calculating the present value of the asset (equity or company) based on projections of how much it will be worth after a certain period of time. The logic behind the DCF valuation is based on the time value of money. A $1 today won’t be worth the same after a year because of inflation, tax pressures and so on. Similarly, the value of equity or a company won’t be the same as today. With DCF valuation analysts calculate the expected cash flows that the asset will generate based on its cash flows, growth and risk.
Besides, because stock markets can be highly volatile, analysts typically make a reasonable prediction about the asset’s future earnings and discount them by calculating their present value. DCF valuation method uses expected free cash flows (FCF) and discounts them with the risk free rate and risk premium to calculate the present value. In effect, the value of the equity is calculated by discounting expected cash flows to equity after taking into consideration tax obligations and interest and principal payments at the cost of equity, which all represent the rate of return required by equity investors in the firm.
The principle of market inefficiency basically assumes that because markets are inefficient, assets are not priced correctly. On the other hand, markets are able to correct themselves as soon as new information about the assets becomes available (market efficiency). Therefore, the forecast of the expected cash flows in terms of growth rate or profit margin becomes easier as soon as new information becomes available for this company.
In general, DCF valuation method is a good method for investors to know what assets they are actually buying. Because it takes into consideration the intrinsic value of the asset, which can only be estimated based on the unique characteristics of the asset, investors get to know the underlying characteristics of the company, the company culture, and how it does business. In doing so, they are more conscious about their investment decision making and ready to anticipate their assumptions about the asset’s price. Besides, especially for inexperienced investors, DCF valuation is a great tool to check the fair value prices provided by analysts as well as the discount rate. If everything seems reasonable based on the company’s fundamentals, historical data, and the industry it operates, but also the broader economic environment including inflation and the risk-free interest rate, then equity value is more likely to be reasonable thus making investment safer.
Although, DCF valuation method is not flawless and sometimes analysts may use it to manipulate asset values and make some investments look more attractive, is one of the most effective valuation methods and definitely one of the most widely used. Given that any company on the globe aims at generating a return on investment and free cash flow after operating expenses are deducted, DCF valuation is the best method to use for evaluating if an asset is worth investing. If the value derived from DCF valuation is higher than the current market price, the investment opportunity should be taken into consideration.