A Practical Guide to Understanding and Using Discounted Cash Flow in Investment Valuation

Discounted cash flow (DCF) is a method of valuing an investment or asset based on the present value of its expected future cash flows. The time value of money is taken into account in the DCF calculation, as it recognizes that money has a different value at different points in time due to factors such as inflation and opportunity cost.

How Does DCF Work?

To understand how DCF works, let’s consider a simple example. Imagine that you are considering investing in a company that is expected to generate a single cash flow of $100 one year from now, and you expect to earn a 15% return on your investment.

To determine the present value of this cash flow, you can use the following formula:

Present Value = Future Cash Flow / (1 + Discount Rate)^Number of Periods

In this case, the present value of the expected cash flow would be:

Present Value = $100 / (1 + 15%)^1

= $87.04

Working with Multiple Cash Flows

Now, let’s say that you are trying to determine the value of an investment that is expected to generate a series of cash flows over a longer period of time, such as ten years. In this case, you can use the DCF method to calculate the present value of each expected cash flow and sum them up to determine the value of the investment.

Present Value of Each Cash Flow

For example, the present value of the first year’s cash flow would be:

Present Value = $100 / (1 + 15%)^1

= $87.04

The present value of the second year’s cash flow would be:

Present Value = $100 / (1 + 15%)^2

= $74.67

Similarly, the present value of the third year’s cash flow would be:

Present Value = $100 / (1 + 15%)^3

= $63.82

And so on, until you have calculated the present value of all ten years of expected cash flow.

Determining the Value of the Investment

To determine the value of the investment, you can sum up the present value of all the expected cash flows. In this case, the value of the investment would be:

Value of Investment = $87.04 + $74.67 + $63.82 + … + $38.46

= $523.41

This means that, according to the DCF calculation, the value of the investment is $523.41, assuming a 15% discount rate.

Factors that Affect the Value of an Investment Using DCF

Several factors can affect the value of an investment using the DCF method. These include:

• The expected cash flows: The value of the investment will be higher if the expected cash flows are higher.
• The discount rate: The higher the discount rate, the lower the value of the investment, as a higher discount rate reflects a higher opportunity cost or risk.
• The length of time over which the cash flows are expected: The longer the time period over which the cash flows are expected, the lower the value of the investment, as there is more time for potential changes in market conditions or other factors that could affect the cash flows.

Using DCF in Investment Decision Making

Now that you understand the basics of DCF, how can you use it to make investment decisions?

One way to use DCF is to compare the value of an investment calculated using DCF to the current market price of the investment. If the DCF value is higher than the current market price, the investment may be undervalued and could be a good buy. If the DCF value is lower than the current market price, the investment may be overvalued and could be a poor investment. It’s important to note that the DCF method is just one tool that investors can use in their decision-making process, and it should be used in conjunction with other analysis techniques such as financial ratio analysis and industry analysis.

In conclusion, discounted cash flow is a valuable method of valuing an investment or asset based on the present value of its expected future cash flows. By taking into account the time value of money and considering factors such as the expected cash flows, the discount rate, and the length of time over which the cash flows are expected, investors can use DCF to make informed investment decisions and maximize returns.

• Check out our course on Statement of Cash Flows