What It Measures
Discounted cash flow (DCF) is a way of measuring the net present value (NPV) of future cash flow. This allows companies to express the value of an investment today based on predicted future returns. The idea behind discounted cash flow is that $1 today is worth more than $1 you might receive in the future. The money you have now can be invested and might generate interest whereas money you haven’t yet received can’t be used in this way, and there is a risk it might not be received. Therefore, discounted cash flow is a way of adjusting the value of future money over time to reflect its “real” value today.
Why It Is Important
Discounted cash flow is most useful when future operating conditions and cash flow are variable, or where trading conditions are expected to change significantly over time. It is a good way of assessing the likely value of money the business will receive in future, and therefore DCF is considered one of the best ways of valuing an investment.
How It Works in Practice
To calculate discounted cash flow, you must first determine the forecasted cash flow of a company, and choose a discount rate based on the expected or desired rate of return. The discount rate chosen should reflect the risk that the return will not be achieved—a higher risk should result in a higher discount rate.
Next, use the discount rate for each year to discount cash flow to the “correct” adjusted present value, as shown in the example below. Remember, cash flow will lose value over time because it is discounted for a longer period.
NPV = CF1 ÷ (1 + r) + CF2 ÷ (1 + r)2 + CF3 ÷ (1 + r)3
where NPV is the net present value of cash flows, CF1, CF2, and CF3 are predicted cash flows in years 1, 2, and 3, respectively, and r is the discount rate. It’s worth remembering that, unless the series of cash flows has a known finite endpoint, a terminal value will need to be assumed.
Tricks of the Trade
There are many variations to the calculation illustrated above, and different ways to measure cash flow and discount rates in a DCF calculation. All the different approaches are basically ways of estimating the return from an investment, adjusted for the time value of money.
Like many calculations, a DCF figure is only as good as the figures used for cash flow and discount rates. Small changes in these figures can result in enormous variation in NPV figures, so it’s often wiser to use DCF over a relatively short period of time and to adopt a terminal value approach, rather than discounting to infinity.