Lisa Borga

Date Published: November 16, 2021

## What is Discounted Cash Flow (DCF)?

Discounted cash flow (DCF) is a financial model that is used to determine what an investment is currently worth by projecting its future cash flows.

DCF is useful for people who invest in companies or securities, whether they are buying a company or stock in a corporation.

Business owners also find this valuation method useful for making decisions about budgeting for new projects or investments.

## Key Highlights of DCF

• DCF can help investors to determine if an investment is worthwhile by forecasting the projected future cash flows.
• The discount rate is used to calculate DCF or, in other words, the current value of projected cash flows.
• If an investment DCF is greater than its current cost, it may be a good opportunity.
• For most businesses, the discount rate is the weighted average cost of capital (WACC.) This is due to how it takes the rate of return that shareholders can expect into account.
• DCF does have some limitations, such as inaccuracy resulting from the predicted cash flows.

## Discounted Cash Flow (DCF) Formula

(Cash flow for the first year / (1+r)1)+(Cash flow for the second year / (1+r)2)+(Cash flow for N year / (1+r)N)+(Cash flow for final year / (1+r)

r = discount rate

N = period of time

## How to Use Discounted Cash Flow

A DCF is used to estimate how much money an investor will receive from a proposed investment when the investment is adjusted to account for the time value of money.

The time value of money is the idea that money today provides more benefits than an equal amount of money in the future due to the ability to earn interest on the money.

This makes DCF a useful tool in any case in which someone pays out money but expects to get additional money in turn later.

Suppose the annual interest rate is 3%, and someone puts \$10.00 dollars in savings.

In one year, they will have \$10.30.

If payment is not received for one year, it will have a present value of \$9.62 because you will be unable to invest it.

Generally, companies will use their weighted average cost of capital (WACC) as the discount rate when calculating the discounted cash flow.

By using (WACC), companies can account on the amount their shareholders would expect to make in return for financing its assets.

### Example

Suppose a business is considering an investment and their WACC is 4%, so the discount rate will be 4%.

The business’s initial investment will be nine million, and the investment will continue for a period of six years.

When added up, the discounted cash flows are \$12,635,264.

When the \$15 million initial investment is subtracted, the net present value is \$2,364,736.

This project is a good choice since there is a profit even after the future cash flows are discounted.

## The Limitations of DCF

When calculating cash flows in the future, it’s essential not to estimate them too high, or you could find yourself picking a project that will not make money.

However, if you estimate cash flows that are too low, it could cause the investment to look more costly than it really is, potentially causing you to pass up a good investment.

Discount rates are an estimate, but they must be calculated carefully to ensure this financial model is useful.

## How is DCF Calculated?

In order to calculate DCF, you will perform a series of steps. The first is to forecast the investment’s expected future returns.

Next, you will determine an interest rate (discount rate), and this is normally calculated by taking into account the potential cost of alternative investments you could make with the same level of risk.

Lastly, you will apply your discount rate to the investment’s predicted cash flows.

This can be done manually or through a computer application or financial calculator.

## DCF Calculation Example

Suppose the discount rate is 7% and the opportunity for an investment that would return \$250 for the next four years.

You want to know what the value of this investment is today or, in fewer words, its present value for this future income stream.

Since money earned in the future is not as valuable as money now, you will use your 7% discount rate to reduce the future returns of this investment to their present value.

## What Is the Difference Between DCF and Net Present Value (NPV)?

DCF and NPV are very similar in concept.

However, to find the NPV, another calculation is added to the discounted cash flows.

After the predicted cash flows are calculated, the discount rate is selected, and the cash flows are discounted, NPV requires that the initial investment in the project be deducted from the DCF of the investment.

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1. Harvard Business School "Company Valuation Using Discounted Cash Flow" Page 1 . November 16, 2021

2. NYU Stern "DISCOUNTED CASHFLOW MODELS: WHAT THEY ARE AND HOW TO CHOOSE THE RIGHT ONE.." Page 1 . November 16, 2021

3. Wichita Center for Management Development "Discounted Cash Flow: Application and Misapplication" White paper. November 16, 2021