Discounted Cash Flow

discounted-cash-flowDiscounted cash flow is one of the common valuation methodologies that is being used among practitioners. The discounted cash flow relies on 2 components which are (i) projection or estimation of future cash flow and (ii) apply the appropriate discount factor.

It is important to understand the structure of the financial product in order to correctly project the future cash flows. There are a few points to take note which are the timing of the cash flow and the amount of the cash flow. The cash flow timing and its amount may or may not follow a fixed schedule. In practice, the term sheet of any financial instruments should state the cash flow timing and cash flow amount to inform all relevant parties.

However, there are times where the cash flow timing and cash flow amount could not be determined. One example is the future dividend of any equities. Analysts would need to estimate the timing as well as the amount of the future dividend. The estimation process may involve investigating previous dividend announcement or study the company’s financial statement and its composition board of directors. Note that there are many other factors that could be used to estimate future dividends.

Since these cash flows happen in the future, therefore, discounting is needed to determine the value of each cash flow to a valuation date. Recall time value of money which explains that $1 today may worth more than $1 tomorrow. However, the issue here to apply the correct discounting factor to each cash flow. In most finance courses, the risk free rate is used to derive the discounting factor, particularly.

In our world, however, there is no riskless investment vehicle. Some practitioners recommend adding spreads to the risk free rate such as inflation rate, liquidity spread, credit spread and default spread. Determining the correct discounting factor is part art and part science. Art in the sense that which spread should be added on top of the risk free rate, science in the sense that why such spread should be added and the exact amount of spread that is to be added on top of the risk free rate. Regardless, the main point is to find out the appropriate discount factor.

A concluding point on discounted cash flow, it is a simple valuation model with assumptions that may not reflect the real world. The model is intuitive and easy to understand, however, users of this model need to be aware of its assumptions.

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