The Basic of DCF Model (Discount Cash Flow): Present Value Calculation of Future Cash Flows
It is essential to convert future cash flows into today’s value for business valuation. The value of $100 that companies create today is different from $100 expected in five years.
Cash flows after five years may have two risks.
First, it does not reflect the inflation rate so that it might have a lower value than today’s $100.
Second, if the business risk is high, the likelihood of actually generating $100 in five years is lower than in today. Financially, the possibility of creating more than $100 is called upside risk, and the one of creating less than $100 is called downside risk.
When using the DCF model (Discounted Cash Flow model), it is essential to calculate and convert future cash flows to present value. In practice, most of this is done with an Excel spreadsheet. Just with a few logic on the sheet, the present value calculations become more straightforward, and you can do more complex valuation models at ease. The basic formula for the present value calculation is as follows.
‘n’ is the duration of the business. In the case of companies, you could apply infinity for that because they are usually assumed to be running permanently. ‘r’ is the discount rate used for present value calculation with future cash flows. The more stable the cash flow, the lower it is, and the more unstable, the higher it is. CFt is the cash flow you can expect from the business at time t. If the cash flow is a dividend, it becomes the DDM (Dividend Discount Model), and if it is free cash flow, it becomes the FCF (discounted Free Cash Flow) model.
Timeline and present value calculation
Present value calculation of future cash flows begins with drawing a timeline. Here, the timeline means a simple line that sets the present as 0 and lists the future cash flows over time. Let’s take an example with one-time cash flow in the future.
The cash flow of $100 after 5 years is plotted on the timeline in the case above. 0 means present, 5 means five years later, and $100 represents a positive cash flow of $100 or a cash inflow of $100. Using the formula introduced earlier, when you calculate the present value of $100 after five years at a discount rate of 10%, it will be about $62. In other words, if the discount rate is 10%, the value of $62 now is the same as $100 after five years.
$62 = $100 / (1+0.1)5
Time intervals are usually annual, and you can divide them by quarter, semi-annual, or monthly as needed. Cash flow will be positive (+) cash flow if income is higher than expenditure, and negative (-) cash flow if the expenditure is higher than income.
The present value calculation of multiple cash flows
If there are multiple cash flows rather than one cash flow, the timeline will look like this:
The above timeline shows the cash flows generated during n periods. In the first year, $100 was created, in the second year, -$50, in the third year, $200, and in the n year, $300. The box below the 0-time point shows the cash flows generated at each time point calculated as a present value at a discount rate of 5%. When adding all these together, it becomes the total business value.
As mentioned earlier, you can apply the above DCF model formula not only to companies but to all investment assets that generate cash flows in the future. If the target asset is an office, you can put the net operating profit expected from the office in CFt. Then, V0 will be the office value. If the target asset is a real estate project, V0 will become the NPV (Net Present Value) by placing the project’s cost and revenue in CFt.