Last editedApr 20222 min read
Discounted cash flow is a means of estimating how much an asset is worth in the present due based on cash flow projections. It’s therefore a way of informing you how much you can spend on an investment today in order to see a desired return in the future.
In this post we’ll go define in detail the term discounted cash flow, plus take you through the discounted cash flow formula so that you can calculate it for yourself.
What is discounted cash flow for?
Discounted cash flow is used by investors to decide whether it will be profitable to invest in a business or project. This is because it demonstrates the value of an investment. It can be applied to projects, property, bonds, stock, businesses and essentially any kind of investment that will lead to cash flow. However, it should always be taken with a pinch of salt since it relies on estimates and assumptions to be calculated.
Discounted Cash Flow Calculation (DCF Formula)
The discounted cash flow calculation can be straightforward or complicated depending on the elements it contains. However, either way, it’s always based on the following discounted cash flow formula:
DCF = CFt / (1+r)^t
If you’re not aware of what these symbols mean, here’s a quick explanation:
CFt – Cash flow for the given year.Cash flow is the amount of money coming in and out of a business, represented by inflow and outflow. With a bond, for example, cash flow would comprise both interest and main payments.
r – Discount rate, expressed as a percentage, such as an interest rate.
t – the life of the asset that’s being valued, i.e. how long it will last.
Calculating the DCF therefore involves three steps:
Forecast the expected cash flows from the investment
Determine a discount rate. When a company decides whether it should invest in a project or new equipment, it typically uses its weighted average cost of capital (WACC) for the discount rate when calculating the DCF. The WACC is basically the average rate of return for shareholders in the company in a given year.
Discount the forecasted cash flows back to the present moment. To do this, you can use a financial calculator, a spreadsheet, or do the calculation manually.
Investors can use the DCP to deduce whether the future cash flows of an investment is equal to or greater than the value of their starting investment. If the value calculated through DCF exceeds the initial cost of the investment, then the opportunity is worth considering as it will likely lead to a good return.
Overall, discounted cash flow can be an excellent way to determine whether an investment is worth pursuing or not. If you’re considering investing in a business, purchasing an asset, bond or stock, discounted cash flow analysis can be a great tool to determine possible returns.
However, naturally DSC is a prediction based on certain estimates and assumptions. It therefore shouldn’t be taken as a certainty, and investments that seem to fare well when applied to the discounted cash flow formula, may not do so in reality. Other factors can always unexpectedly influence the return on an investment, such as market crashes and fluctuations.
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