Discounted Cash Flows (DCF) Print

Figure 1

Project A destroys value therefore do not invest in it.
Project B creates value and is thus good for investment.

DCF is one of the most frequently used instruments in financial management. It is used to evaluate a project or a company in order to decide whether to invest in it or not and to assess the risks related to that decision.

Some professionals do not like it because it is quite theoretical. However, if wisely applied, DCF is the most accurate instrument.

Two things are necessary to be able to use it: 1) an object to discount – forecasted cash flows; 2) a factor to discount with – discount rate(s) that reflects the market risk of occurrence of the forecasted cash flows.

The key terms used in the above paragraph are forecasted cash flows and risk. If you manage to calculate them perfectly, the computation of the present value of the project will be absolutely correct!
Some generic notes on the usage of the instrument:

  1. Why cash flows and not profit or revenue? – Because you buy cheese with cash. You cannot buy it against an invoice for a receivable or against your tax statement which shows how profitable you are!
  2. Why future? – Because time changes everything – tomorrow will not be the same as today and all you do today will be reflected tomorrow not yesterday. You could use the past as a basis, informatively, but in order to have a good model you need to look into the future with all its uncertainties and puzzles!
  3. What is risk? – The probability that future cash flows would not happen in the size, with the sign, with the frequency, in the sequence, or in the period they were assumed to happen. You determine the value of the risk by analyzing similar projects on the market. Apparently, the more similar the better. On the other hand, you strive to be different, don’t you? In other words, it’s complicated!
  4. The risk associated with different future periods is different, i.e. the discount rate for different periods should be different – it depends on macroeconomic factors, politics, competition and the fact that you always deal with expectations!

    Several operational notes on the usage of the instrument:
  1. If you need to amend your model due to negative change in your cash flow expectations for instance, you should never do that by increasing (in our case) the discount rate on the former cash flow figures, just because it is easier. No formula exists under which to perform this swap rightfully!
  2. When the project is an addition to your current business activity and not a completely separate investment, its inherent cash flows are those that increase marginally (positive or negative) because of its launch. If, for instance, this project does not incur additional administrative cost then you do not add such to its negative cash flows, i.e. you do not use averages!
  3. You may get to a point in the development of the project when you stop and contemplate and realize that things are not at all developing as initially planned. Then there is just one option – forget the past, if all done so far is irreversibly lost, and take as basis what has been already established and make its own DCF analysis from scratch with no remorse for the past – it is sunk cost. You should have thought better, earlier!
  4. In the process of valuing your project you should include as outflows the usage of all assets that you already possess and decided to utilize in this project. The latter should generate the targeted return on the total investment no matter when it was made. Alternatively you could at least sell these assets and receive a cash inflow!
  5. You should forecast cash flows up until the moment when you assume they become normalized thus relatively constant thereon. At this point you just calculate the terminal value and add it to the rest.
  6. You should never count on a single valuation technique to establish the value of your project. A single method carries a lot of noise. You always combine it with at least two other – market multiples, comparable deals or else. Then you take the weighted average of all. The weights you determine on an expert basis.
  7. If you have to choose between two mutually exclusive projects, invest in the one that would bring more absolute value and not the other that would be relatively more profitable. The second might be more effective but the first would make you rich!



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