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11/3/18, 4(59 AMDiscounted Cash Flow | QFinance: The Ultimate Resource - Credo Reference

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Discounted Cash Flow

from QFinance: The Ultimate Resource

WHAT IT MEASURES

Discounted cash flow (DCF) is a way of measuring the net present value (NPV) of

future cash flow. This allows companies to express the value of an investment

today based on predicted future returns. The idea behind discounted cash flow is

that $1 today is worth more than $1 you might receive in the future. The money you

have now can be invested and might generate interest whereas money you

haven't yet received can't be used in this way, and there is a risk it might not be

received. Therefore, discounted cash flow is a way of adjusting the value of future

money over time to reflect its “real” value today.

WHY IT IS IMPORTANT

Discounted cash flow is most useful when future operating conditions and cash

flow are variable, or where trading conditions are expected to change significantly

over time. It is a good way of assessing the likely value of money the business will

receive in future, and therefore DCF is considered one of the best ways of valuing

an investment.

HOW IT WORKS IN PRACTICE

To calculate discounted cash flow, you must first determine the forecasted cash

flow of a company, and choose a discount rate based on the expected or desired

rate of return. The discount rate chosen should reflect the risk that the return will

not be achieved—a higher risk should result in a higher discount rate.

Next, use the discount rate for each year to discount cash flow to the “correct”

adjusted present value, as shown in the example below. Remember, cash flow will

lose value over time because it is discounted for a longer period.

For example:

NPV = CF1/(1 + r) + CF2/(1 + r) + CF3/(1 + r)

where NPV is the net present value of cash flows, CF1, CF2, and CF3 are predicted

cash flows in years 1, 2, and 3, respectively, and r is the discount rate. It’s worth

remembering that, unless the series of cash flows has a known finite endpoint, a

net present value in QFinance: The

Ultimate Resource

cash inflows minus cash

outflows the value of an

investment calculated as

the sum of its initial cost

and the present value of

expected future cash f

417 words from A&C

Black

Discounted cash flow (DCF) in Dictionary of

Environmental Science

and Technology

A common technique

used to evaluate the

relative costs of

proposed schemes.

Knowing the rate of

interest available, we

can calculate what

value...

397 words from Wiley

Net present value (NPV) in International

Encyclopedia of

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terminal value will need to be assumed.

TRICKS OF THE TRADE

Cash flows may represent interest payments or repayments, or in the case

of stocks can relate to dividends.

There are many variations to the calculation illustrated above, and different

ways to measure cash flow and discount rates in a DCF calculation. All the

different approaches are basically ways of estimating the return from an

investment, adjusted for the time value of money.

Like many calculations, a DCF figure is only as good as the figures used for

cash flow and discount rates. Small changes in these figures can result in

enormous variation in NPV figures, so it’s often wiser to use DCF over a

relatively short period of time and to adopt a terminal value approach, rather

than discounting to infinity.

DCF analysis of cash flow should be used when a business case deals with

two potential uses of money, and wherever cash flow timing is different.

MORE INFO

Article:

McClure, Ben. “DCF analysis.” Investopedia. Online at:

www.investopedia.com/university/dcf/.

Website:

Solution Matrix on DCF: www.solutionmatrix.com/discountedcash-flow