Discounted Cash Flow (DCF): Meaning And Examples

“DCF: Turning future potential into present value.”

Whenever we invest or make purchases, understanding the potential future returns in present is crucial. This allows us to compare today’s investment with future outcomes. To accurately assess these returns, we rely on the Discounted Cash Flow method(DCF). This method discount the future returns and helps us figure out how much future cash will be worth today. That way, we can see if our investment now is worth it compared to what we’ll get later. Companies use this method to rank or compare their projects.

What is Discounted Cash Flow(DCF)

DCF is a method used to estimate the value of an investment by considering its future cash flows and discounting them to their present worth. It helps investors assess whether an investment is financially worthwhile by comparing the present value of expected returns with the initial investment.

How DCF works

a) Estimate future cash flows

b) use discounting rate ( interest you are expecting from investment or Time value of money) to get present value of future cash flows.

c) Then add all discounted cash flows and subsequently compare with you initial investment. If the added Cash flow is more than the initial investment then you can invest in the project.

Formula

• DCF is the Discounted Cash Flow.
• CF1, CF2, CF3, …, CFn are the cash flows in periods 1, 2, 3, …, n.
• r is the discount rate, or the rate of return required on the investment.
• n is the number of periods.

Example

Suppose you are considering investing $27000 in a business and you expect will generate the following cash flows over the next three years:

• Year 1: $10,000
• Year 2: $12,000
• Year 3: $15,000

Let’s also assume that your required rate of return on this investment is 10% per year.

Using the DCF formula, the value of this investment would be calculated as follows:

Calculating each term separately:

• The present value of the Year 1 cash flow is: $10,000 / (1.10) = $9,090.91
• The present value of the Year 2 cash flow is: $12,000 / (1.10)^2 = $9,917.36
• The present value of the Year 3 cash flow is: $15,000 / (1.10)^3 = $11,157.02

Adding these up, the total DCF or the value of the investment is:

DCF= $9,090.91 + $9,917.36 + $11,157.02 = $30,165.29

So, according to the DCF method, the present value of this investment is approximately $30,165.29. Which is more than $27000 hence we should invest in project.

Advantages and
Disadvantages

Advantages and Disadvantages of Discounted Cash Flow

Advantages

• Complete Picture: DCF looks at all future money the investment could make.
• Value of Money Over Time: It understands that money now is worth more than the same amount in the future.
• Flexible: DCF can be used for many types of investments in different areas.
• Helps Decision-Making: It helps decide if an investment is worth it by showing expected returns.

Disadvantages

• Complex: DCF uses many assumptions and detailed financial models, so it can be hard to get right.
• Subjective: It depends heavily on guesses of future money, which can be biased.
• Sensitive: Small changes in things like growth rates can greatly change the value.
• Risk of Misunderstanding: If results are misunderstood or data is wrong, it can lead to bad investment decisions.

Conclusion

Discounted Cash Flow (DCF) analysis serves as a crucial tool for investors and businesses alike, providing a comprehensive understanding of the potential value of an investment by considering future cash flows. By discounting these cash flows to their present worth, DCF enables informed decision-making regarding the viability of projects or investments.

While DCF offers numerous advantages such as offering a complete picture of future returns and considering the value of money over time, it also poses challenges including its complexity, subjectivity, and sensitivity to assumptions. Nevertheless, mastering DCF empowers individuals and organizations to make sound investment choices, optimizing their financial outcomes in the dynamic landscape of investment opportunities.