In this post, we’ll unpack all you need to know about Discounted Cash Flow, defining exactly what it is, its significance in evaluating investment opportunities, a step-by-step guide on how to calculate it and more.
What Is Discounted Cash Flow?
Discounted Cash Flow (DCF) is a type of financial analysis method. It is used to estimate the attractiveness of an investment opportunity by determining the present value of future cash flows.
Why Is Discounted Cash Flow Important To Know?
Discounted Cash Flow is a fundamental concept in finance and investing.
DCF allows us to estimate what an investment is worth in the present, based on projections of how much money it will generate in the future. It takes into account the time value of money (TVM) which acknowledges a dollar today is worth more than a dollar tomorrow.
If the value arrived at through DCF analysis is higher than the current cost of the investment, then the opportunity may be desirable. If the value arrived at through DCF analysis is lower than the current cost of the investment, then the opportunity may be undesirable.
By allowing us to calculate the intrinsic value of an investment, DCF allow us to asses risk, compare opportunities and ultimately make more informed investment decisions.
How To Calculate Discounted Cash Flow
To save time, you can use a DCF Calculator to determine the value of your investment. However, it is still important to understand how the Discounted Cash Flow is actually calculated.
Firstly, project the amount of money you expect the investment to generate each year of the forecast period.
Secondly, select a discount rate. This is the rate of return that you expect the investment to generate each year of the forecast period. The discount rate takes into account the risk-free rate (which reflects the return of an alternative investment that carries zero risk), inflation (which accounts for the decrease in the purchasing power of money over time) and a risk premium (which compensates for the risk or uncertainty associated with the specific investment).
For example, if the risk-free rate is 2%, expected inflation is 3% and the risk premium is 4%, the discount rate would be 9% (2 + 3 + 4 = 9).
Thirdly, calculate the present value of future cash flows by applying your selected discount rate.
Finally, add together all the present values. The sum is the total DCF of your investment which represents the current value of the expected future cash flows.
It’s important to remember that DCF is based on your expectations of future cash flows and required rate of return. Therefore, the accuracy of your outputs (calculations) will be determined by the accuracy of your inputs.
How To Calculate DCF Summary
- Estimate Future Cash flows
- Select A Discount Rate
- Calculate Present Value Of Future Cash Flows
- Sum Present Values Of All Future Cash Flows
Summary (TL;DR)
Discounted Cash Flow is a method used to estimate the present value of an investment based on future cash flows.
DCF is calculated by projecting future cash flows and then discounting them back to the present using an appropriate rate. If the DCF value is higher than the current cost of the investment, then the opportunity may be undesirable. If the DCF value is lower than the current cost of the investment, then the opportunity may be undesirable.
Understanding DCF is crucial in assessing risk, comparing different investments and making more informed investment decisions.
