## What is a discounted cash flow (DCF)?

Discounted cash flow (DCF) refers to a Evaluation method that estimates the value of an investment using its expected future cash flow.

DCF analysis attempts to determine the value of an investment today, based on projections of the amount of money that investment will generate in the future.

It can help those who are considering acquiring a business or buying securities to make their decisions. Discounted cash flow analysis can also help business owners and managers make capital budgeting or operating expense decisions.

Key points to remember

- Discounted cash flow analysis helps determine the value of an investment based on its future cash flows.
- The present value of expected future cash flows is obtained using a projected discount rate.
- If the DCF is higher than the current cost of the investment, the opportunity could result in positive returns and may be attractive.
- Companies typically use the weighted average cost of capital (WACC) for the discount rate because it takes into account the rate of return expected by shareholders.
- A disadvantage of DCF is that it relies on estimates of future cash flows, which may turn out to be inaccurate.

Discounted cash flow (DCF)

## How does discounted cash flow (DCF) work?

The purpose of DCF analysis is to estimate the money an investor would receive from an investment, adjusted for the the time value of money.

The time value of money assumes that a dollar you have today is worth more than a dollar you will receive tomorrow because it can be invested. As such, a DCF analysis is useful in any situation where a person pays money in the present with expectations of receiving more money in the future.

For example, assuming an annual interest rate of 5%, $1 in a savings account will be worth $1.05 per year. Similarly, if a $1 payment is delayed for a year, its present value is 95 cents because you cannot transfer it to your savings account to earn interest.

The discounted cash flow analysis reveals current value expected future cash flows using discount rate. Investors can use the concept of the present value of money to determine whether future cash flows from an investment or project are greater than the value of the original investment.

If the calculated DCF value is higher than the current cost of the investment, the opportunity should be considered. If the calculated value is lower than the cost, it may not be a good opportunity. Or, more research and analysis may be needed before moving forward.

To perform a DCF analysis, an investor must make estimates about future cash flows and the ultimate value of the investment, equipment, or other asset.

The investor should also determine an appropriate discount rate for the DCF model, which will vary depending on the project or investment being considered. Factors such as the company’s or investor’s risk profile and capital market conditions may affect the discount rate chosen.

If the investor cannot estimate future cash flows or the project is very complex, the DCF will not have much value and alternative models should be used.

For DCF analysis to be useful, the estimates used in the calculation should be as robust as possible. Incorrectly estimated future cash flows that are too high can lead to an investment that may not be sufficiently profitable in the future. Similarly, if future cash flows are too low due to rough estimates, they may make the investment appear too expensive, which could lead to missed opportunities.

## Discounted cash flow formula

The formula for DCF is: