How to calculate discounted cash flow
0
min read
Discounted cash flow refers to a valuation method of assessing how much an investment is worth based on its expected future cash flows. Essentially, discounted cash flow analysis attempts to understand the value of an investment today, based on projections of how much money it will generate in the future.
Given that it looks at future performance based on estimates from the current state of the business, it is inherently limited in its accuracy. The longer the projection period over which you estimate future revenue and expenditure, the greater the scope for differences between expectation and reality to widen.
This article will explore why discounted cash flow matters, how it is calculated, and some differences between discounted cash flow and other types of cash flow.
Why does discounted cash flow matter?
The discounted cash flow model matters because it helps investors know if an investment in a company is a risk worth taking. For example, if a business is projected to bring in far more money than expected expenses in the coming decade, then investors will be inclined to acknowledge its potential value based on its discounted cash flow.
Discounted cash flow is also commonly used in the real estate industry, in which people can buy a property based on its potential value in the coming years. Let’s say that a neighbourhood is set to undergo gentrification.
A real estate investor can use discounted cash flow to calculate the expected annual yield that they might expect to receive from investing in property. They could calculate this using our example below and then compare with other investments to determine the value of investing.
The discounted cash model can be used with virtually all investment opportunities by helping investors predict whether their investment will be profitable. Read on to find out the formula to calculate it.
How to calculate discounted cash flow
To determine the discounted cash flow (DCF) of an investment, follow these three essential steps:
- Project Future Cash Flows Estimate the cash flows you expect the investment to generate over a specific period. This involves forecasting revenue, operating costs, and other financial variables.
- Choose a Discount Rate Select an appropriate discount rate, which typically reflects the cost of financing the investment or the opportunity cost of choosing this investment over others.
- Calculate the Present Value Using a discounted cash flow calculator, spreadsheet, or manual methods, discount the projected cash flows back to their present value. This will give you the DCF.
Discounted cash flow formula
You can use a basic formula to calculate the discounted cash flow model on any given investment opportunity. Before you get started, make sure you have:
- the initial cost of the investment
- any interest rates
- the expected expenses and profits of each year
- the holding period (how long you plan to own the property).
The discounted cash flow formula is as follows:
Cash Flow (year 1) / (Rate of Return + 1) ^1 +
Cash Flow (year 2) / (Rate of Return +1) ^ 2 +
Cash Flow (year 3) / (Rate of Return +1) ^ 3 +
(continue for the entire holding period)
Discounted cash flow example
Let’s say that an investor wants to purchase a new property to rent out and generate some passive income. They find a house that is worth £150,000 in an up-and-coming village and pay in full with cash. The house needs to be remodelled, which will cost an additional £50,000 and takes the total investment to £200,000.
The investor then plans to rent the property for £1,200 per month in the first year. They allocate £200 of this to expenses, meaning they will generate £1,000 in cash flow each month and £12,000 over the year.
Since rent prices often increase, the investor predicts a 2% yearly increase in the rent that they will receive. For example, monthly rent in year 2 would be £1,020 (£1,000 x 102%). Using this formula, the investor can now calculate the number of years that it will take to receive their full investment back. For example:
By using this discounted cash flow model, the investor will see a full return on their initial £200,000 investment after 16 years. So, using this formula can be helpful for small businesses because it shows you how long it will take to see a return on your investment.
How to use discounted cash flow analysis in your businesses
Discounted Cash Flow (DCF) analysis is an invaluable tool for small business owners, providing insights that go beyond simple profit and loss statements. By evaluating the present value of expected future cash flows, DCF helps in making informed decisions about investments and business strategies such as:
- Evaluating Capital Expenditures: When deciding whether to invest in new machinery, technology, or facilities, DCF can help determine if the future cash flows generated by these investments will justify the upfront costs.
- Assessing Business Expansion: If you’re considering opening a new branch or expanding your product line, DCF analysis can evaluate whether the expected increase in cash flows will outweigh the expansion costs.
- Funding and Financing Decisions: DCF can be used to assess the viability of taking on new debt or equity financing. By understanding the future cash flows, you can ensure that your business will be able to meet its financial obligations.
- Acquisitions and Mergers: For businesses looking to acquire or merge with another company, DCF provides a method to value the target company accurately, ensuring the acquisition price reflects the true potential of future earnings.
- Valuing Intangible Assets: DCF is particularly useful for valuing intangible assets like patents, trademarks, or proprietary technology. By estimating the future cash flows these assets will generate, you can determine their current worth.
- Exit Strategy Planning: If you’re planning to sell your business, DCF helps in setting a fair selling price by projecting future cash flows and discounting them to present value. This ensures you receive an equitable return on your investment.
Finding the right source of finance for your investments
If you're looking to finance an investment to grow and expand your business, iwoca offers tailor made small business loans to suit your needs.
With flexible loan options and quick access to funds, iwoca helps small businesses reach their goals with full control and transparency. To find out how much you could borrow, try our small business loan calculator.
{{iwoca-pay-cta="/components"}}
