Discounted Cash Flow

Discounted Cash Flow is an accounting method used when analyzing an investment and determining its attractiveness. In this method, future cash flows are estimated and discounted, giving them a present value. If the value arrived at is higher than the current cost of the investment, then the opportunity should be a good one. There are actually four different approaches to the Discounted Cash Flow method: flows to equity approach, adjusted present value approach, weighted average cost of capital approach, and total cash flow approach.

The Discounted Cash Flow method must take into account many different things when determining the value of an investment such as how risky it is, the size of the company being studied, the time period that the investment will be held for, the debt to equity ratio, real or nominal basis of cash projections, and income tax considerations. Even though the different calculations may seem complex, the purpose of Discounted Cash Flow analysis is simply to estimate the monies you'd receive from an investment, adjusting for the time value of money.

Author Ronald W. Hilton states that there are four assumptions to be withheld when calculating Discounted Cash Flow. First, cash flows are to be treated as though they occur at year’s end. Cash flows associated with investment projects are treated as though they were known with certainty. Cash inflows are assumed to be reinvested in other investments, earning money for the company. Finally, Discounted Cash Flow analysis assumes a perfect capital market. While these four assumptions are not usually satisfied, they still provide an effective means of investment analysis.

The time value of money plays a huge part in the Discounted Cash Flow method and can be confusing for those with little knowledge of it. It’s not that difficult however, when you consider and understand how the value of money changes over time. When asked whether he or she would rather have a dollar today or a dollar tomorrow, the answer will almost certainly be today. This combined with factors such as inflation make money more valuable today then in the future. That is in essence the purpose of the Discounted Cash Flow model, to take what a company will make in the future and discounting it to present value.

The Discount Cash Flow rate reflects the risk premium, that is the return in excess of the “risk-free rate of return” that an investment is expected to provide. An asset's risk premium is a method of payment for investors who don’t mind the extra risk, compared to a risk-free asset or investment. Discounted Cash Flow reveals the additional return investors wish for because they want to be paid for the risk that the cash flow might not provide a return after all.

When calculating the Discounted Cash Flow, keep in mind that its purpose is merely to provide an estimate, not a precise number. You will find that depending on different method and figures that an investment’s value can change dramatically. Therefore, don’t become too preoccupied with the details and specific numbers.