How to calculate discounted cash flow
Discounted cash flow
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. Investors look at the discounted cash flow of a company before making a capital investment, purchasing stock, or acquiring the business.
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 neighborhood 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.
What is the 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.
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