Is the DCF Valuation Model Overrated?

The discounted cash flow model (DCF) is used by investors in order to determine what the potential future value of an investment may be based on the future cash flows of the investment.

An example could be, if an investor purchases a house today, in 10 years, they will aim for it to sell for more than it is worth today. However, there is also income and expenses generated from the property during that 10 year period which can drastically change the overall value of the investment. If the property is a rental property, then there will be cash flow from rent as an example. Renovations and improvements over the years will cause cash flow exiting the investment. The discounted cash flow model will utilise all of these varying cash flow events in order to calculate what the future value of the investment could be.

The discounted cash flow model will help investors to evaluate the cash going into an investment, the timing of the cash expenditure, and the cash flow from the investment, as well as when the investor has access to the funds from the investment. It can then be utilized to determine whether the future value of the investment based on all of these variables is worth the risk level to the investor.

Calculating a Discounted Cash Flow

The DCF model has a relatively basic formula in order to calculate the future value. The main complexity of the DCF is having all of the varying data metrics, and making sure that they are accurate. For example, having inflated future cash inflows, or underestimating future expenses will lead to an inaccurate result which could result in a poor investment, or a missed opportunity. Therefore, a DCF model is only as valuable as the data which you put into it. 

In order to gather the data, you should make sure you have the accurate cost of the investment, as well as any accurate estimations of year-on-year expenses as well as reliable cash inflows in each year. Then, you will need to conclude on the holding period, as some investments may become valuable over a longer period than others. Typically, an investment holding period when using a DCF model is 5 to 15 years.

The following formula can be used in order to calculate the discounted cash flow:

DCF = CF1 / (1 + r) 1 + CF2 / (1 + r) 2 + … + CFN / (1 + r)N

DCF = Discounted Cash Flow

CF = Cash Flow

r = discounted rate

Each aspect of the DCF formula will allow investors to evaluate the cash flow of the investment by a particular year in order to see the cash which is flowing in from the investment. The subsection will then repeat itself for the number of years that you estimate you will hold the investment.

Some aspects to consider when looking at an investment:

• Initial Investment: The cost of purchasing the investment initially
• Income: This could be rental income, dividends, general cash flow
• Expenses: Upkeep costs, renovations, cost of debt, utilities etc
• Sales Proceeds: The proceeds earned in the year the investment was liquidated

It can be a confusing formula to follow initially, but there are also opportunities to use excel in order to determine a discounted cash flow. The formula in excel is ‘=NPV’

When to use a Discounted Cash Flow

Investors will generally use the DCF in order to determine an investment's value in the future in order to determine whether the onset of risk now is worth the reward in the future. From a banking perspective, many investment bank analysts will use the DCF formula in order to know whether an investment in a business is a worthy long-term investment. This can be used to determine whether the future value of an investment is a fair value, or represents the true value of the company (whether it is over or undervalued).

The core downside of the DCF though is that it relies significantly on estimates, as it is impossible to predict the future income and expenses of an investment with 100% accuracy for many years to come. Therefore, if the estimates going into the formula are bad, the resulting valuation of the future value of the investment will also be inaccurate.

Is the Discounted Cash Flow Better than other models?

Some other options which many investors will use are the Internal Rate of Return (IRR), Net Present Value, Cash Flow, Cash on Return or Cap Rates. These can be used to assess investments, as well as property’s potential value as a basis for investment decisions.

The discounted cash flow model differs slightly from other valuation methods because it allows investors to determine the value of projected future cash flows when compared to today’s time. The IRR formula will actually use the discounted cash flow as its basis in order to determine an investment’s up or downside.

It is certain that the discounted cash flow model is not perfect. However, it is a significant help in allowing investors to evaluate the expected/predicted cash flows coming in and out of an investment at a risk-free rate over their expected holding period. From this, they can determine the future value of their cash investment, and come to an educated conclusion on whether the cash outlay today will be worth the overall return in the future when considering annual income, annual expenses and the overall factor of time. This brings the time value of money as a consideration. $1,000 today is far more valuable from a time perspective than $1,000 in 20 years' time for example. It is that key distinction which allows the DCF model to decipher whether an investment is worth participating in.