{"id":2972,"date":"2021-10-21T06:12:00","date_gmt":"2021-10-21T06:12:00","guid":{"rendered":"https:\/\/rakshithpai.com\/?p=2972"},"modified":"2021-10-21T16:04:20","modified_gmt":"2021-10-21T16:04:20","slug":"discounted-cash-flow-model-importance","status":"publish","type":"post","link":"https:\/\/rakshithpai.com\/discounted-cash-flow-model-importance\/","title":{"rendered":"Discounted Cash Flow model &#8211; DCF &#038; its importance!"},"content":{"rendered":"\n<div id=\"ez-toc-container\" class=\"ez-toc-v2_0_65 counter-hierarchy ez-toc-counter ez-toc-grey ez-toc-container-direction\">\n<p class=\"ez-toc-title\">Table of Contents<\/p>\n<label for=\"ez-toc-cssicon-toggle-item-663d2c6d3af79\" class=\"ez-toc-cssicon-toggle-label\"><span class=\"\"><span class=\"eztoc-hide\" style=\"display:none;\">Toggle<\/span><span class=\"ez-toc-icon-toggle-span\"><svg style=\"fill: #999;color:#999\" xmlns=\"http:\/\/www.w3.org\/2000\/svg\" class=\"list-377408\" width=\"20px\" height=\"20px\" viewBox=\"0 0 24 24\" fill=\"none\"><path d=\"M6 6H4v2h2V6zm14 0H8v2h12V6zM4 11h2v2H4v-2zm16 0H8v2h12v-2zM4 16h2v2H4v-2zm16 0H8v2h12v-2z\" fill=\"currentColor\"><\/path><\/svg><svg style=\"fill: #999;color:#999\" class=\"arrow-unsorted-368013\" xmlns=\"http:\/\/www.w3.org\/2000\/svg\" width=\"10px\" height=\"10px\" viewBox=\"0 0 24 24\" version=\"1.2\" baseProfile=\"tiny\"><path d=\"M18.2 9.3l-6.2-6.3-6.2 6.3c-.2.2-.3.4-.3.7s.1.5.3.7c.2.2.4.3.7.3h11c.3 0 .5-.1.7-.3.2-.2.3-.5.3-.7s-.1-.5-.3-.7zM5.8 14.7l6.2 6.3 6.2-6.3c.2-.2.3-.5.3-.7s-.1-.5-.3-.7c-.2-.2-.4-.3-.7-.3h-11c-.3 0-.5.1-.7.3-.2.2-.3.5-.3.7s.1.5.3.7z\"\/><\/svg><\/span><\/span><\/label><input type=\"checkbox\" style='display:none' id=\"ez-toc-cssicon-toggle-item-663d2c6d3af79\"  aria-label=\"Toggle\" \/><nav><ul class='ez-toc-list ez-toc-list-level-1 ' ><li class='ez-toc-page-1 ez-toc-heading-level-2'><a class=\"ez-toc-link ez-toc-heading-1\" href=\"https:\/\/rakshithpai.com\/discounted-cash-flow-model-importance\/#Introduction\" title=\"Introduction:\">Introduction:<\/a><\/li><li class='ez-toc-page-1 ez-toc-heading-level-2'><a class=\"ez-toc-link ez-toc-heading-2\" href=\"https:\/\/rakshithpai.com\/discounted-cash-flow-model-importance\/#How_to_calculate_DCF\" title=\"How to calculate DCF?\">How to calculate DCF?<\/a><\/li><li class='ez-toc-page-1 ez-toc-heading-level-2'><a class=\"ez-toc-link ez-toc-heading-3\" href=\"https:\/\/rakshithpai.com\/discounted-cash-flow-model-importance\/#Why_DCF_analysis_is_Important\" title=\"Why DCF analysis is Important?\">Why DCF analysis is Important?<\/a><\/li><li class='ez-toc-page-1 ez-toc-heading-level-2'><a class=\"ez-toc-link ez-toc-heading-4\" href=\"https:\/\/rakshithpai.com\/discounted-cash-flow-model-importance\/#Shortcomings_of_the_DCF_model\" title=\"Shortcomings of the DCF model!\">Shortcomings of the DCF model!<\/a><\/li><li class='ez-toc-page-1 ez-toc-heading-level-2'><a class=\"ez-toc-link ez-toc-heading-5\" href=\"https:\/\/rakshithpai.com\/discounted-cash-flow-model-importance\/#For_more_information_check_our_YouTube_video\" title=\"For more information, check our YouTube video:\">For more information, check our YouTube video:<\/a><ul class='ez-toc-list-level-3' ><li class='ez-toc-heading-level-3'><a class=\"ez-toc-link ez-toc-heading-6\" href=\"https:\/\/rakshithpai.com\/discounted-cash-flow-model-importance\/#Also_read\" title=\"Also read:\">Also read:<\/a><\/li><\/ul><\/li><\/ul><\/nav><\/div>\n<h2 class=\"wp-block-heading\"><span class=\"ez-toc-section\" id=\"Introduction\"><\/span><strong>Introduction:<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h2>\n\n\n\n<p><strong>Discounted cash flow (DCF) is a way of valuing an investment that is used to determine its value based on its predicted future cash flows<\/strong>. DCF analysis is used to determine the current value of an investment based on future cash flow estimates. If the value arrived at through the DCF model is higher than the current cost of the investment, then it is considered a good opportunity to invest.<\/p>\n\n\n\n<div class=\"wp-block-buttons is-content-justification-center is-layout-flex wp-block-buttons-is-layout-flex\">\n<div class=\"wp-block-button is-style-outline\"><a class=\"wp-block-button__link has-text-color has-background\" href=\"https:\/\/zerodha.com\/open-account?c=PR4768\" style=\"border-radius:50px;background-color:#e4fa00;color:#0f0027\" rel=\"nofollow\"><strong>Open Zerodha Account Now!<\/strong><\/a><\/div>\n<\/div>\n\n\n\n<h2 class=\"wp-block-heading\"><span class=\"ez-toc-section\" id=\"How_to_calculate_DCF\"><\/span><strong>How to calculate DCF?<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h2>\n\n\n\n<p>Let&#8217;s take a <strong>hypothetical example.&nbsp;<\/strong><\/p>\n\n\n\n<p>There&#8217;s a company named <strong>&#8220;Mr. Pai Industries&#8221;<\/strong>. This company is valued at Rs. 100 crores with 10 crore outstanding equity shares. Hence, the per-share price is Rs. 10. The company also has 30 crores in debt &amp; other liabilities. <\/p>\n\n\n\n<p><strong>Suppose this is the cash flow of the company for the next 5 years. And, the company&#8217;s weighted average cost of capital (WACC) is at 10% p.a. <\/strong><\/p>\n\n\n\n<div class=\"wp-block-image\"><figure class=\"aligncenter size-large is-resized\"><img loading=\"lazy\" decoding=\"async\" src=\"https:\/\/rakshithpai.com\/wp-content\/uploads\/2021\/09\/Cash-flow-for-5-years-1024x557.jpg\" alt=\"\" class=\"wp-image-2975\" width=\"1182\" height=\"643\" srcset=\"https:\/\/rakshithpai.com\/wp-content\/uploads\/2021\/09\/Cash-flow-for-5-years-1024x557.jpg 1024w, https:\/\/rakshithpai.com\/wp-content\/uploads\/2021\/09\/Cash-flow-for-5-years-300x163.jpg 300w, https:\/\/rakshithpai.com\/wp-content\/uploads\/2021\/09\/Cash-flow-for-5-years-768x418.jpg 768w, https:\/\/rakshithpai.com\/wp-content\/uploads\/2021\/09\/Cash-flow-for-5-years.jpg 1200w\" sizes=\"(max-width: 1182px) 100vw, 1182px\" \/><\/figure><\/div>\n\n\n\n<blockquote class=\"wp-block-quote is-layout-flow wp-block-quote-is-layout-flow\">[WACC is a method for calculating <strong>a firm&#8217;s cost of capital that weights each category of capital proportionately.<\/strong> A WACC computation considers all sources of capital, including common stock, preferred stock, bonds, and any other long-term debt, to arrive at one rate, which is the overall cost of capital for the company.]<\/blockquote>\n\n\n\n<p>We then use the WACC figures as the discount rate for the future year&#8217;s estimated cash flow figures to make an estimate of what the company could be worth now.&nbsp;<strong>Where &#8220;CF&#8221; stands for &#8220;Cashflow&#8221; and &#8220;r&#8221; represents the &#8220;discount rate&#8221; or the &#8220;WACC rate&#8221;. We do this calculation for multiple periods to arrive at the present enterprise value.<\/strong><\/p>\n\n\n\n<div class=\"wp-block-image\"><figure class=\"aligncenter size-full is-resized\"><img loading=\"lazy\" decoding=\"async\" src=\"https:\/\/rakshithpai.com\/wp-content\/uploads\/2021\/09\/Discounted-Cash-Flow-DCF-Formula.jpg\" alt=\"\" class=\"wp-image-2973\" width=\"1184\" height=\"593\" srcset=\"https:\/\/rakshithpai.com\/wp-content\/uploads\/2021\/09\/Discounted-Cash-Flow-DCF-Formula.jpg 549w, https:\/\/rakshithpai.com\/wp-content\/uploads\/2021\/09\/Discounted-Cash-Flow-DCF-Formula-300x150.jpg 300w\" sizes=\"(max-width: 1184px) 100vw, 1184px\" \/><\/figure><\/div>\n\n\n\n<p>Then, based on the arrived figures <strong>(Rs.134.75 crores)<\/strong>, we just need to subtract the net debt of the company, which is <strong>Rs.30 crores<\/strong>, to get the fair value of the company which is <strong>Rs.104.75 crores<\/strong> (Rs.134.75 &#8211; 30). Now, we just compare the arrived fair value figures <strong>(Rs.104.75 crores)<\/strong> with the current market price of the company <strong>(Rs.100 crores)<\/strong> to judge whether the company is overvalued or undervalued and invest accordingly.<\/p>\n\n\n\n<div class=\"wp-block-buttons is-content-justification-center is-layout-flex wp-block-buttons-is-layout-flex\">\n<div class=\"wp-block-button is-style-outline\"><a class=\"wp-block-button__link has-text-color has-background\" href=\"https:\/\/zerodha.com\/open-account?c=PR4768\" style=\"border-radius:50px;background-color:#e4fa00;color:#0f0027\" rel=\"nofollow\"><strong>Open Zerodha Account Now!<\/strong><\/a><\/div>\n<\/div>\n\n\n\n<p>In this case, <strong>&#8220;Mr. Pai Industries&#8221;<\/strong> is a company valued at Rs. 134.75 crore and when debt is deducted, <strong>we arrive at the company&#8217;s fair value at Rs. 104.75 crore.<\/strong> And, <strong>Based on the market value of the company at Rs. 100 crores, we can see that the company is undervalued.<\/strong><\/p>\n\n\n\n<div class=\"wp-block-image\"><figure class=\"aligncenter size-full is-resized\"><img loading=\"lazy\" decoding=\"async\" src=\"https:\/\/rakshithpai.com\/wp-content\/uploads\/2021\/09\/Mr-Pai-Industries.jpg\" alt=\"\" class=\"wp-image-2976\" width=\"501\" height=\"522\" srcset=\"https:\/\/rakshithpai.com\/wp-content\/uploads\/2021\/09\/Mr-Pai-Industries.jpg 751w, https:\/\/rakshithpai.com\/wp-content\/uploads\/2021\/09\/Mr-Pai-Industries-288x300.jpg 288w\" sizes=\"(max-width: 501px) 100vw, 501px\" \/><\/figure><\/div>\n\n\n\n<h2 class=\"wp-block-heading\"><span class=\"ez-toc-section\" id=\"Why_DCF_analysis_is_Important\"><\/span><strong>Why DCF analysis is Important?<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h2>\n\n\n\n<p>DCF analysis is used to determine the amount of money an investor would receive from an investment, adjusted for the time value of money. <strong>The time value of money hypothesizes that a dollar today is worth more than a dollar tomorrow due to its investment potential.<\/strong> As such, a DCF analysis is suitable in every case in which a person makes a payment in the present with the hope of receiving additional funds in the future.<\/p>\n\n\n\n<p>For instance, if the yearly interest rate is 5%, Rs.100 in a savings account will be worth Rs.105 after a year. Similarly, if you delay an Rs.100 payment for a year, its present value will be Rs.95 or less, as you cannot deposit it in a savings account to collect interest.<\/p>\n\n\n\n<p><strong>Using a discount rate, DCF analysis determines the present value of predicted future cash flows. <\/strong>Investors can use the present value of money idea to analyze whether the future cash flows from an investment or project are equal to or greater than the initial investment&#8217;s value. If the DCF value is more than the investment&#8217;s present cost, the opportunity should be explored.<\/p>\n\n\n\n<p>To perform a DCF analysis, an investor must make assumptions about future cash flows and the ultimate value of the investment, equipment, or other assets. Additionally, <strong>the investor must select an appropriate discount rate for the DCF model, which will vary depending on the project or investment, as well as the firm or investor&#8217;s risk profile and capital market conditions.<\/strong> If the investor does not have access to future cash flows or the project is extremely complex, DCF is of little utility and other models should be used.<\/p>\n\n\n\n<h2 class=\"wp-block-heading\"><span class=\"ez-toc-section\" id=\"Shortcomings_of_the_DCF_model\"><\/span><strong>Shortcomings of the DCF model!<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h2>\n\n\n\n<p>The primary shortcoming of DCF is that it <strong>necessitates numerous assumptions.<\/strong> For one thing, an investor must <strong>accurately forecast future cash flows from an investment or project.<\/strong> Future cash flows would be contingent on a range of things, including market demand, economic conditions, technology, competition, and unforeseen dangers or opportunities.<\/p>\n\n\n\n<p><strong>Overestimating future cash flows can result in selecting an investment that does not pay off in the long run,<\/strong> reducing profits. Calculating cash flows incorrectly, which makes the investment appear expensive, can result in wasted opportunities. Selecting a discount rate for the model is another assumption that must be made accurately in order for the model to be worthwhile.<\/p>\n\n\n\n<h2 class=\"wp-block-heading\"><span class=\"ez-toc-section\" id=\"For_more_information_check_our_YouTube_video\"><\/span><strong>For more information, check our YouTube video:<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h2>\n\n\n\n<figure class=\"wp-block-embed is-type-video is-provider-youtube wp-block-embed-youtube wp-embed-aspect-16-9 wp-has-aspect-ratio\"><div class=\"wp-block-embed__wrapper\">\n<div class=\"ast-oembed-container \" style=\"height: 100%;\"><iframe loading=\"lazy\" title=\"What is the Discounted Cash Flow model DCF?\" width=\"500\" height=\"281\" src=\"https:\/\/www.youtube.com\/embed\/eTqhnVRrOEc?feature=oembed\" frameborder=\"0\" allow=\"accelerometer; autoplay; clipboard-write; encrypted-media; gyroscope; picture-in-picture; web-share\" referrerpolicy=\"strict-origin-when-cross-origin\" allowfullscreen><\/iframe><\/div>\n<\/div><\/figure>\n\n\n\n<p>   <\/p>\n\n\n\n<div class=\"wp-block-buttons is-content-justification-center is-layout-flex wp-block-buttons-is-layout-flex\">\n<div class=\"wp-block-button is-style-outline\"><a class=\"wp-block-button__link has-text-color has-background\" href=\"https:\/\/zerodha.com\/open-account?c=PR4768\" style=\"border-radius:50px;background-color:#e4fa00;color:#0f0027\" rel=\"nofollow\"><strong>Open Zerodha Account Now!<\/strong><\/a><\/div>\n<\/div>\n\n\n\n<p><strong><strong>Disclaimer: <\/strong><\/strong>All the information on this website is published in good faith and for general information purpose only.    <\/p>\n\n\n\n<h3 class=\"wp-block-heading\"><span class=\"ez-toc-section\" id=\"Also_read\"><\/span><strong>Also read:<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h3>\n\n\n\n<ul><li><strong><a href=\"https:\/\/rakshithpai.com\/best-investment-plans-india-middle-class\/\">Best Investment Plans in India for Middle Class<\/a><\/strong><\/li><li><strong><a href=\"https:\/\/rakshithpai.com\/how-to-invest-in-stock-market-a-beginners-guide-to-investing\/\">How to Start Investing? A Beginners Guide to Investing<\/a><\/strong><\/li><li><strong><a href=\"https:\/\/rakshithpai.com\/how-to-construct-a-profitable-investment-portfolio\/\">How To Construct a Profitable Investment Portfolio?<\/a><\/strong><\/li><li><strong><a href=\"https:\/\/rakshithpai.com\/investing-in-your-20s\/\">Investing tips in your 20s<\/a><\/strong><\/li><li><strong><a href=\"https:\/\/rakshithpai.com\/investing-in-your-30s\/\">Investing tips in your 30s<\/a><\/strong><\/li><li><strong><a href=\"https:\/\/rakshithpai.com\/portfolio-allocation-asset-correlation-importance\/\">Portfolio Allocation, Asset Correlation &amp; its importance!<\/a><\/strong><\/li><li><strong><a href=\"https:\/\/rakshithpai.com\/best-warren-buffett-quotes\/\">Best Warren Buffett Quotes<\/a><\/strong><\/li><\/ul>\n","protected":false},"excerpt":{"rendered":"<p>Introduction: Discounted cash flow (DCF) is a way of valuing an investment that is used to determine its value based on its predicted future cash flows. DCF analysis is used to determine the current value of an investment based on future cash flow estimates. If the value arrived at through the DCF model is higher [&hellip;]<\/p>\n<div class='heateor_sss_sharing_container heateor_sss_vertical_sharing heateor_sss_bottom_sharing' style='width:44px;right: -10px;top: 100px;background-color: Dark Blue' data-heateor-sss-href='https:\/\/rakshithpai.com\/wp-json\/wp\/v2\/posts\/2972'><div class=\"heateor_sss_sharing_ul\"><a aria-label=\"Facebook\" class=\"heateor_sss_facebook\" href=\"https:\/\/www.facebook.com\/sharer\/sharer.php?u=https%3A%2F%2Frakshithpai.com%2Fwp-json%2Fwp%2Fv2%2Fposts%2F2972\" title=\"Facebook\" rel=\"nofollow noopener\" target=\"_blank\" style=\"font-size:32px!important;box-shadow:none;display:inline-block;vertical-align:middle\"><span class=\"heateor_sss_svg\" style=\"background-color:#0765FE;width:40px;height:40px;margin:0;display:inline-block;opacity:1;float:left;font-size:32px;box-shadow:none;display:inline-block;font-size:16px;padding:0 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Here to spread the concept of \u201cSane Investing\u201d.","sameAs":["https:\/\/rakshithpai.com","https:\/\/www.facebook.com\/Iam.Mrpai","https:\/\/www.instagram.com\/iam_mrpai","https:\/\/www.linkedin.com\/in\/iam-mrpai","https:\/\/in.pinterest.com\/Iam_MrPai","https:\/\/x.com\/Iam_MrPai","https:\/\/www.youtube.com\/channel\/UC3vfc8G1sysZleCAKbytRFQ?view_as=subscriber"],"url":"https:\/\/rakshithpai.com\/author\/mrpai27\/"}]}},"uagb_featured_image_src":{"full":["https:\/\/rakshithpai.com\/wp-content\/uploads\/2021\/09\/What-is-the-Discounted-Cash-Flow-model-DCF-5.jpg",1200,675,false],"thumbnail":["https:\/\/rakshithpai.com\/wp-content\/uploads\/2021\/09\/What-is-the-Discounted-Cash-Flow-model-DCF-5-150x150.jpg",150,150,true],"medium":["https:\/\/rakshithpai.com\/wp-content\/uploads\/2021\/09\/What-is-the-Discounted-Cash-Flow-model-DCF-5-300x169.jpg",300,169,true],"medium_large":["https:\/\/rakshithpai.com\/wp-content\/uploads\/2021\/09\/What-is-the-Discounted-Cash-Flow-model-DCF-5-768x432.jpg",768,432,true],"large":["https:\/\/rakshithpai.com\/wp-content\/uploads\/2021\/09\/What-is-the-Discounted-Cash-Flow-model-DCF-5-1024x576.jpg",1024,576,true],"1536x1536":["https:\/\/rakshithpai.com\/wp-content\/uploads\/2021\/09\/What-is-the-Discounted-Cash-Flow-model-DCF-5.jpg",1200,675,false],"2048x2048":["https:\/\/rakshithpai.com\/wp-content\/uploads\/2021\/09\/What-is-the-Discounted-Cash-Flow-model-DCF-5.jpg",1200,675,false],"web-stories-poster-portrait":["https:\/\/rakshithpai.com\/wp-content\/uploads\/2021\/09\/What-is-the-Discounted-Cash-Flow-model-DCF-5.jpg",640,360,false],"web-stories-publisher-logo":["https:\/\/rakshithpai.com\/wp-content\/uploads\/2021\/09\/What-is-the-Discounted-Cash-Flow-model-DCF-5.jpg",96,54,false],"web-stories-thumbnail":["https:\/\/rakshithpai.com\/wp-content\/uploads\/2021\/09\/What-is-the-Discounted-Cash-Flow-model-DCF-5.jpg",150,84,false]},"uagb_author_info":{"display_name":"Rakshith Pai","author_link":"https:\/\/rakshithpai.com\/author\/mrpai27\/"},"uagb_comment_info":0,"uagb_excerpt":"Introduction: Discounted cash flow (DCF) is a way of valuing an investment that is used to determine its value based on its predicted future cash flows. DCF analysis is used to determine the current value of an investment based on future cash flow estimates. If the value arrived at through the DCF model is higher&hellip;","_links":{"self":[{"href":"https:\/\/rakshithpai.com\/wp-json\/wp\/v2\/posts\/2972"}],"collection":[{"href":"https:\/\/rakshithpai.com\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/rakshithpai.com\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/rakshithpai.com\/wp-json\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/rakshithpai.com\/wp-json\/wp\/v2\/comments?post=2972"}],"version-history":[{"count":7,"href":"https:\/\/rakshithpai.com\/wp-json\/wp\/v2\/posts\/2972\/revisions"}],"predecessor-version":[{"id":3177,"href":"https:\/\/rakshithpai.com\/wp-json\/wp\/v2\/posts\/2972\/revisions\/3177"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/rakshithpai.com\/wp-json\/wp\/v2\/media\/2979"}],"wp:attachment":[{"href":"https:\/\/rakshithpai.com\/wp-json\/wp\/v2\/media?parent=2972"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/rakshithpai.com\/wp-json\/wp\/v2\/categories?post=2972"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/rakshithpai.com\/wp-json\/wp\/v2\/tags?post=2972"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}