Discounted Cash Flow

Discounted cash flow (DCF) is a valuation method that estimates what an asset or a whole business is worth today, based on the cash it is expected to produce in future, with each future amount reduced to its present value. A dollar received in three years is worth less than one received today, so DCF discounts each future amount back.

If that present value comes to more than the investment costs, the numbers support going ahead. If it comes to less, they do not.

What is the discounted cash flow formula?

DCF = CF1/(1+r)1 + CF2/(1+r)2 + … + CFn/(1+r)n

CF is the expected cash flow in each period. r is the discount rate. Each period is divided by a larger number than the one before it, which is why cash further out contributes less to the total. Valuations of whole businesses usually add a terminal value at the end to stand for everything beyond the forecast horizon.

How do you calculate discounted cash flow?

Take a project expected to produce $50,000 in year one, $60,000 in year two and $70,000 in year three, discounted at 12%.

The project's future cash adds up to $180,000 on paper. In today's money it is worth $142,299. Anything you can pay below that figure leaves value on your side of the deal.

What is the discount rate, and how do you choose one?

The discount rate is the minimum return you would accept for tying up your money for the length of the project. It carries the risk of the cash not arriving, the effect of inflation, and what you would have earned putting the same money somewhere else. Raise the rate and future cash flows are worth less today. Lower it and more of their value survives the discounting.

Larger businesses usually use their weighted average cost of capital (WACC), which blends what they pay on debt with the return equity holders expect. A small business without that kind of capital structure can use a simpler proxy: the rate its bank charges on borrowing, plus a few points for the risk that the cash flows miss. A business borrowing at 9% might discount a routine equipment purchase at 12% and a speculative new location at 18%.

Because the rate moves the answer so much, run the calculation at two or three rates and look at the spread rather than defending one number. See discount rate for more on how the rate is built.

What is the difference between DCF and NPV?

DCF is the present value of the future cash flows on their own. Net present value (NPV) takes that figure and subtracts what you pay upfront.

In the example above, if the project costs $120,000 to start, the DCF is $142,299 and the NPV is $142,299 minus $120,000, or $22,299. A positive NPV means the investment adds value at the rate you chose. A negative NPV means it destroys value, and the size of the gap tells you how much room you have to be wrong about your assumptions.

When should you use DCF?

DCF earns its keep on decisions where you can forecast the cash with reasonable confidence and the time horizon is clear:

• Buying equipment. Does the extra output or the labour it saves over the asset's life beat the purchase price?
• Acquiring a business. Value the target on the cash it is projected to produce, then compare that with the asking price.
• Expanding. Discount the additional cash a new location or product line could bring in against the cost of launching it.
• Signing a multi-year lease or contract. A commitment that runs for five years is a series of future cash flows, and it can be discounted the same way.

It works less well on early-stage or highly uncertain ventures, where the future cash is close to a guess, and it says nothing about factors that never reach the cash flow statement, such as brand or strategic fit.

What is terminal value in a DCF?

When you value an entire business rather than a project with an end date, you add a terminal value to stand for all the cash arriving after your forecast window closes. It is commonly calculated either by growing the final year's cash flow at a modest perpetual rate, or by applying an exit multiple to that year's earnings.

Terminal value often accounts for more than half of the total valuation, and it sits in the years you know least about. Test it at more than one growth rate before you rely on the total.

What are the limits of DCF?

DCF applies exact arithmetic to uncertain inputs, and the precision of the output can hide how soft the inputs are. Small changes in a growth assumption or a couple of points on the discount rate move the answer materially. Treat the result as a range shaped by your assumptions rather than a single true number, and write down the assumptions alongside it so anyone reviewing the valuation can see what it rests on.

How does discounted cash flow affect your cash flow?

A DCF is only as good as the cash flow forecast underneath it. Guessed inputs produce guesswork with decimals after it. The cash flows you discount should come from the same place as the forecast you run the business on: invoices you have raised, bills you owe, payroll dates, loan repayments, and the payment behaviour your customers have actually shown.

Cash Flow Frog builds that projection from your live accounting data, up to three years rolling, with drill-down to the individual transactions behind any figure. So when you discount year three, you are discounting a number you can trace, not a straight line drawn on a spreadsheet. If your underlying forecast is not solid yet, start with how to build a cash flow forecast.