Discounted Cash Flow: How to Calculate Discounted Cash Flow

Discounted cash flow (DCF) is a valuation method that businesses and individuals apply to potential investments. By using a DCF analysis that projects future cash flows, investors estimate the rate of return on an asset to estimate its fair value after years of ownership. The discounted cash flow method is popular in the world of corporate finance, private equity, and investment banking. By using financial modeling metrics and projecting expected cash flows, business owners can estimate an asset's growth rate and decide whether it is worthy of the investment.

A discounted cash flow analysis will ultimately produce what's called the net present value (NPV) of an asset. In the simplest terms, the NPV is the expected future value of the asset minus its asking price. If the NPV is a positive number, the asset may be considered a good investment. If, after applying the discounted cash flow model, an analyst estimates a negative net present value (NPV), the asset may be a poor investment and should thus be avoided.

The discounted cash flow formula has four key inputs.

• CF1: The cash flow for Year One
• CF2: The cash flow for Year Two
• n: A future time period measured in years
• CFn: The cash flow for future years
• r: The discount rate or internal rate of return (IRR)

To calculate discounted cash flow, plug these inputs into the DCF formula:

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

This produces a projected future value of an asset (such as stock, real estate, equipment, or an acquired business) while discounting that amount to reflect present-day dollar amounts. In other words, the DCF model estimates the market value of an asset at the end of a fixed time period.

Discounted cash flow is used to predict the future value of assets, based on the time value of money—which assumes that a dollar today is worth more than a dollar in the future because a present-day dollar can be invested. When an investor considers purchasing a new asset (such as real estate, equipment, shares of stock, or even an entire company), they use the DCF method to decide whether the investment will be profitable down the line.

Two key factors go into estimating a DCF valuation.

• Free cash flow projections: The future value of a company or piece of property will hinge upon projected cash inflows such as revenue from customers, rental fees, or an increased stock price. Forecasting cash flows is an inexact science; accurately predicting the value of a company or asset will depend on the quality of one's free cash flow projection.
• Cost of debt: Investments come with their own financial obligations. If you must borrow money to make a capital expenditure, you must factor the weighted average cost of capital (WACC) in your DCF model. You must pay interest on borrowed money; what's more, investors in a capital venture usually expect regular dividends—sometimes before the asset truly appreciates. If the cost of equity overwhelms a company's balance sheet, the investment may not pay off in the long run.

NPV stands for net present value. This is the value investors seek when applying the DCF calculation to an investment. Effectively, an investor will apply the discounted cash flow formula to determine the potential future value of the company or asset. They will then subtract the purchase price of the investment to arrive at a net present value or NPV.

If the net present value (NPV) of a potential investment is a positive number, this means its projected future value exceeds the current purchase price. It thus offers strong value as a long-term investment. If the NPV is negative, this means the future value of the asset appears to be lower than its current asking price. This means it may be a bad investment.

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