Discounted cash flow (DCF) models are a cornerstone of the business world, helping to fuel decision-making across many different industries. Despite technological advances, DCF analysis remains a crucial skill for emerging graduates to master when looking to build a career in the financial sector. Mastering this concept is a surefire way to make yourself an attractive candidate in the job market.
To further help themselves stand out, undergraduate students should consider the Master of Business Administration (MBA) with a Concentration in Finance online program from the University of North Carolina at Pembroke (UNC Pembroke). Pursuing an MBA can help expand your career opportunities and set you on a path to becoming a well-rounded financial business leader. That said, let’s examine DCF and its role in corporate finance.
What Is Discounted Cash Flow?
DCF is a type of financial analysis that helps companies determine the attractiveness of an investment. DCF analysis involves calculating the value of an asset today based on how much money it should generate in the future. According to the Corporate Finance Institute (CFI), companies will leverage DCF analysis for tasks like:
- Stock valuation: Determining the value of a stock based on future revenue expectations
- Assessing projects: Determining how much money to invest in growth projects based on how much these projects could earn in the future
- M&A activity: Determining how much one company might pay to acquire another based on how much the second company is expected to earn
However, DCF analysis is not only valuable for analyzing investments. It also supports the budgeting process. This is because most DCF models rely on budgeted cash flows. According to software company Cube, combining DCF analysis with the budgeting process can help companies make the best use of their resources by aligning budgets with strategic objectives and prioritizing investments with the highest return.
Time Value of Money Consideration
DCF analysis works due to a concept called the time value of money (TVM). TVM states that today’s dollar is worth more than a dollar in the future since a dollar today can be invested so that it grows over time. DCF and TVM work hand in hand to help companies understand the present value of future cash flows, often by using a standard rate of return, such as the weighted average cost of capital. This calculation can help companies understand if certain investments are “worth it” financially.
Pitfalls of DCF Analysis
DCF is by no means a 100% perfect analysis tool. In fact, Investopedia highlights three pitfalls of DCF:
- The uncertainty of cash flow projections: DCF analysis relies heavily on cash flow projections, which are just educated estimates. While these estimates make sense on paper, the real world is often unpredictable and these estimates can change at any moment. Additionally, projections naturally become less certain the further into the future they go.
- The uncertainty of capital expenditure projections: Projecting cash flows also requires companies to project capital expenditures, which can fluctuate vastly with each year. Companies may dramatically cut expenses in a down year but then ramp up spending in another year.
- Issues surrounding discount rate and growth rate assumptions: Conducting cash flow analysis requires the analyst to use an assumption for the discount or growth rate. However, these rates can be arbitrary, and most models assume that the growth rate will continue in perpetuity, a rare assumption in the real world.
These pitfalls are why companies must employ talented financial analysts who can leverage DCF analysis while identifying potential inaccuracies or providing more context to an outcome. Additionally, since DCF isn’t perfect, future financial professionals should understand how projections play into the broader business picture instead of focusing entirely on the numbers themselves.
Advancing Your Financial Career
If you’re looking to rise quickly through the corporate ranks, earning an MBA is an ideal opportunity. An MBA teaches you the basics of financial modeling using DCF and helps you become a well-rounded business professional.
Some programs even offer a concentration in finance. For example, UNC Pembroke’s online MBA in Finance program offers a course called Corporate Finance, which develops key skills and knowledge necessary for corporate financial leaders, including:
- Performance metrics
- Cashflow analysis
- Long-term strategic thinking
- Growth management
- Costs, risks and payout assessment
- Capital structure optimization
This course also emphasizes how to identify the impact of taxes, distress and insufficient data on the effectiveness of a company’s capital structure. Students can complete this program fully online in as few as 12 months.
Learn more about UNC Pembroke’s online Master of Business Administration with a Concentration in Finance program.
