In the world of finance, discounted cash flow or DCF for short is the method for analyzing and projecting the value of a stock, company, project, real estate, or intellectual property by the estimated time value of money it generates. Discounted cash flow measurement and analysis is used in stock market investing, real estate investing and development, corporate management as well as intellectual property valuation. It is also used in the court system to value assets.
To apply the DCF method, the future cash flows are approximated and then discounted by using the cost of capital to quantify the assets present value (PV). The total amount of all the future cash flows is the final result of all incoming profits minus all outgoing expenses and is called the net present value (NPV), which puts a specific value on the cash flows of the asset being measured.
The discounted cash flow formula is calculated with the future value formula for creating the time value of money with the compounding of returns. Investors can use the discounted cash flow method to analyze and quantify the net present value to take all input cash flows along with a discount rate and create as the output as a present value. The inverse process takes all cash flows and the present value of the asset price as inputs, and gives as output the discount rate; this is used in the bond markets to figure the yield.
Here is the discounted cash flow formula:
- DCF = Discounted cash flow.
- CF1 is for year 1.
- CF2 is for year 2.
- CFn is for additional years.
- r = The discount rate.
Then the discounted current value of one cash flow in one period in the future is shown with the formula:
- DPV is the discounted present value of the future cash flow (FV), or FV adjusted for the delay in receiving it.
- FV equals the reduced real value of a cash flow amount in a future time period.
- r is the real interest rate or discounted rate, which shows the cost of locking in capital and could adjust for the expected risk that the future payout and return could not happen in line with expectations.
- n is the time measurement of years until the future cash flow happens.
Discounted cash flow (DCF) attempts to quantify the value of an investment by its projected future cash flows. Many value investors use the DCF process to measure the potential discount for a stock price. The current value of expected future cash flows is calculated by the use of a discount rate. The focus here is to look at the current price and how much profit that an investment will generate as return on that initial investment. Both the amount of capital return and growth in equity value can be considered on whether an asset is a good investment for growing capital. When the DCF is greater than the current cost of an investment, the investment opportunity has a good risk/return ratio and a high probability of positive future returns. When evaluating companies it is common to use the weighted average cost of capital for the industry it is in to use as the discount rate.
The weakness of using discounted cash flows in making investment decisions is that the risk involved in obtaining future cash flows has to be carefully considered. An investments cash flows can be disrupted by new competition, technology, bad management, disasters, or political upheaval. Considering the timeframe of historical consistency and the risk of future disruption are very important in calculating discounted future cash flows.
