What You Need to Know About Discounted Cash Flow Analysis
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When the world is so unpredictable, how can you know whether a capital project or investment will succeed in the long term?
In 2020 alone, we’ve seen the COVID-19 pandemic create massive devastation and uncertainty. Wildfires have caused destruction across the West Coast. And hurricane season has been particularly brutal along the Atlantic and Gulf coasts.
It seems like anything could go wrong over the course of an investment. So, how do you know if a project or investment is worthwhile?
Enter discounted cash flow analysis: a way to get a clear picture of the profitability of just about any investment opportunity.
Using future cash flow forecasts, discounted cash flow analysis calculates whether returns will exceed the capital outlay presently needed to fund an investment or project. If the value arrived at through the analysis is higher than the cost of capital, it may be a good investment (as long as you plan for an uncertain future).
Here, we’ll take a look at the ways in which discounted cash flow analysis can help your organization. We’ll also show how certain tools can ensure that your DCF analysis takes into account all potential futures, allowing you to make the most well-informed decisions possible.
What is the Discount Rate and Why is it Important?
All sorts of institutions and businesses can benefit from using discounted cash flow (DCF) analysis. It helps you see the present value of an investment.
In simple terms, a discount rate is a rate of return. When you perform DCF analysis, you use that discount rate in the formula to calculate the present value of future cash flows (i.e., you discount future investment profits to find the net present value, or NPV).
Since the financial sustainability of companies, universities, hospitals, and other organizations depends on making smart investments, DCF analysis can serve as a valuable tool and one of your go-to financial models.
You can use the DCF model to estimate the value of all sorts of investments and projects, including:
- An entire business
- A share of stock
- A bond
- An individual business decision
- A capital project or investment
As an example, let’s say you run a real estate investment firm. You want to determine whether buying a particular apartment community would be profitable.
DCF analysis enables you to calculate the current value of that investment while factoring in projections for how much money the apartment community will generate over one year, five years, ten years, or more. After performing the calculation, you can clearly see whether the investment will deliver the returns you want.
This is why it’s so powerful. After all, as an article in Seeking Alpha points out, “a dollar one year from now is worth less than a dollar today.” A proper analysis of any investment opportunity should take that into account.
Using DCF analysis, you can make a more strategic decision when it comes to investing. That’s because it allows you to see the bigger picture and determine what that money today will be worth if you make the investment.
An Example of Discounted Cash Flow Analysis
First, understand that analysts generally use the weighted average cost of capital (WACC) as the discount rate. WACC represents an organization’s cost of capital. The equation to calculate WACC includes stock, bonds, and other forms of equity, as well as debt.
Now, let’s go over an example of discounted cash flow analysis so you can see how it might work for your organization.
Let’s say you run a tech company and want to explore the viability of building two new products. Your goal is to see which product will yield better returns.
Your monetization method for the products will differ:
- For Project A, you'll launch in the market after one year and iterate as you go along.
- For Project B, you'll perform extensive research and development. You'll then sell to a larger company once the product is fully completed after five years.
Based on market research, you forecast the following cash flows for Project A over five years:
|
Year |
Cash Flow |
|
0 |
$6 million initial investment |
|
1 |
$4 million profit |
|
2 |
$8 million profit |
|
3 |
$8 million profit |
|
4 |
$4 million profit |
|
5 |
$0 (product becomes obsolete and must be replaced) |
You then forecast the following cash flows for Project B over five years:
|
Year |
Cash Flow |
|
0 |
$6 million initial investment |
|
1 |
$0 |
|
2 |
$0 |
|
3 |
$0 |
|
4 |
$0 |
|
5 |
$28 million (product is sold to another company/investor) |
Looking at the raw numbers, you’ll see that Project B’s product delivers more money overall ($28 million versus $24 million). However, you must also calculate discounted cash flows.
For your analysis, you’ll use the following formula. Your company’s WACC will be 9% for both projects.
From Investopedia - https://www.investopedia.com/terms/d/dcf.asp
For Project A, here is what your discounted cash flows will look like over five years:
|
Year |
Actual Cash Flow |
Discounted Cash Flow |
|
1 |
$4 million |
$3,669,724 |
|
2 |
$8 million |
$6,733,439 |
|
3 |
$8 million |
$6,177,606 |
|
4 |
$4 million |
$2,833,701 |
|
5 |
$0 |
$0 |
For Project A, the sum of discounted cash flows equals $19,414,470. If we subtract the initial investment of $6 million, you get $13,414,470. That’s the net present value (NPV) of Project A’s investment.
Now, let’s find the net present value of Project B’s investment.
|
Year |
Actual Cash Flow |
Discounted Cash Flow |
|
1 |
$0 |
$0 |
|
2 |
$0 |
$0 |
|
3 |
$0 |
$0 |
|
4 |
$0 |
$0 |
|
5 |
$28 million |
$18,198,079 |
For Project B, the sum of discounted cash flow equals $18,198,079. If we subtract the initial investment of $6 million, you get $12,198,079. That’s the net present value of Project B’s investment.
Therefore, Project A is the more profitable of the two projects. Although the product won’t deliver as much actual cash flow, the net present value of the investment is higher when you account for the time value of money.
From a purely financial standpoint, DCF analysis shows that Project A is more than $1 million better.
Do you see how this analysis can help you make wise investment decisions?
The Problem With Discounted Cash Flow Analysis
There is no such thing as perfect financial modeling. Despite its advantages, discounted cash flow analysis still has drawbacks and risks.
First, analysts often misestimate the discount rate, as there are many factors to consider when estimating the cost of capital. Using an inaccurate discount rate can harm decision-making.
As an article in the Harvard Business Review states, use a cost of capital that’ too high, and you’ll potentially pass up on lucrative opportunities. Conversely, use a cost of capital that’s too low, and you’ll potentially undertake unprofitable projects.
Second, it can be difficult to accurately forecast future cash flows. Cash flow can vary based on a number of factors, such as:
- Market Demand: Consider the example of Project A above. What if a cheaper tech product takes some of your anticipated market share? Then your cash flow would come in lower than anticipated.
- Unforeseen Obstacles: Imagine you work at a university that invested in building a new dormitory in 2017. You expected to generate increasingly more revenue from that dormitory. However, the COVID-19 pandemic derailed cash flow projections from 2020–2021, making the capital project less viable than initially thought.
- Macroeconomic Factors: The financial crisis of 2008–09 impacted virtually every aspect of society. Encountering a recession during an investment could have implications for your business or organization—even if your activities are not directly related to the cause of the recession.
The point is, many factors outside your control can impact projects. It’s nearly impossible to prepare for the unexpected—unless your discounted cash flow analysis is capable of including all potential future scenarios.
But how is that possible?
See Every Scenario in Your DCF Analysis
Your organization’s success relies on having financial models that are not only accurate, but can also help you plan around an uncertain future. It’s simply not feasible to continue relying on static spreadsheets that are vulnerable to human error.
You need a tool that can perform discounted cash flow analysis for all potential future outcomes simultaneously. This way, you can see all the possible scenarios and choose the best investment route.
This is precisely what Synario was made for.
With Photoshop-style layering capabilities, easy-to-use toggle bars, and automated object orientation and financial statements, Synario is the most intelligent financial modeling solution for discounted cash flow analysis. It’s an out-of-the-box solution that can be customized to fit your organization’s situation and help you plan for the unexpected.
The world is unpredictable. But DCF analysis offers you control over that unpredictability, putting you in a position to make the right investment decisions and adjust properly when the unexpected comes.
