Discounted Cash Flow

From Wikicpa

A valuation method used to estimate the attractiveness of an investment opportunity. Discounted cash flow (DCF) analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value, which is used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one.

Discounted Cash Flow (DCF) is what someone is willing to pay today in order to receive the anticipated cash flow in future years. DCF means converting future earnings to today's money. The future cash flows must be discounted in order to express their present values in order to properly determine the value of a company or project under consideration as a whole.

The DCF for an investment is calculated by estimating the cash you will have to pay out and the cash you think you will receive back. The times that you expect to receive the payments must also be estimated. Each cash transaction must then be discounted by the opportunity cost of capital over the time between now and when you will pay or receive the cash.

Example

For example, if inflation is 6%, the value of your money would halve every ±12 years. If you are expecting an asset to give you an income of $30.000 a year in 12 years time, that income stream would be worth $15.000 today if inflation was 6% for the period. We have just discounted the cash flow of $30.000: it's only worth $15.000 to you at this moment.

The DCF method is an approach to valuation, whereby projected future cashflows are "discounted" at an interest rate (also called: "rate of return"), that reflects the perceived riskiness of the cashflows. The discount rate reflects two things:

1. the time value of money (investors would rather have cash immediately than having to wait and must therefore be compensated by paying for the delay)

2. a risk premium that reflects the extra return investors demand because they want to be compensated for the risk that the cash flow might not materialize after all.