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In finance, the discounted cash flow (or DCF) approach describes a method to value a project, company, or financial asset using the concepts of the time value of money. All future cash flows are estimated and discounted to give them a present value. The discount rate used is generally the appropriate cost of capital, and incorporates judgments of the uncertainty (riskiness) of the future cash flows. Image File history File links Broom_icon. ...
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A method for determining the current value of a company using future cash flows adjusted for time value. ...
Finance studies and addresses the ways in which individuals, businesses, and organizations raise, allocate, and use monetary resources over time, taking into account the risks entailed in their projects. ...
The time value of money is the premise that an investor prefers to receive a payment of a fixed amount of money today, rather than an equal amount in the future, all else being equal. ...
This article does not cite any references or sources. ...
The present value of a single or multiple future payments (known as cash flows) is the nominal amounts of money to change hands at some future date, discounted to account for the time value of money, and other factors such as investment risk. ...
The cost of capital for a firm is a weighted sum of the cost of equity and the cost of debt (see the financing decision). ...
Discounted cash flow analysis is widely used in investment finance, real estate development, and corporate financial management. A real estate developer (American English) or property developer (British English) makes improvements of some kind to real property, thereby increasing its value. ...
Mathematics
The discounted cash flow formula is derived from the future value formula for calculating the time value of money and compounding returns. Future value measures what money is worth at a specified time in the future assuming a certain interest rate. ...
The time value of money is the premise that an investor prefers to receive a payment of a fixed amount of money today, rather than an equal amount in the future, all else being equal. ...
 The simplified version of the Discounted cash flow equation (for one cash flow in one future period) is expressed as:  where - DPV is the discounted present value of the future cash flow (FV), or FV adjusted for the opportunity cost of future receipts and risk of loss;
- FV is the nominal value of a cash flow amount in a future period;
- d is the discount rate, which is the opportunity cost plus risk factor (or the time value of money: "i" in the future-value equation);
- n is the number of discounting periods used (the period in which the future cash flow occurs). I.e. if the receipts occur at the end of year 1, n will be equal to 1; at the end of year 2, 2—likewise, if the cash flow happens instantly, n becomes 0, rendering the expression an identity (DPV=FV).
Where multiple cash flows in multiple time periods are discounted, it is necessary to sum them as follows:
For each future cash flow (FV) at any time period (t) for all time periods. The sum can then be used as a net present value figure or used to further calculate the internal rate of return for a cash flow pattern over time. It has been suggested that this article or section be merged with Discounted cash flow. ...
The internal rate of return (IRR) is a capital budgeting method used by firms to decide whether they should make long-term investments. ...
Example DCF To show how discounted cash flow analysis is performed, consider the following simplified example. - John Doe buys a house for $100,000. Three years later, he expects to be able to sell this house for $150,000.
Simple subtraction suggests that the value of his profit on such a transaction would be $150,000 - $100,000 = $50,000, or 50%. If that $50,000 is amortized over the three years, his implied annual return (known as the internal rate of return) would be about 13.6%. Looking at those figures, he might be justified in thinking that the purchase looked like a good idea. For other uses of Amortization, see the Amortization disambiguation page. ...
The internal rate of return (IRR) is a capital budgeting method used by firms to decide whether they should make long-term investments. ...
However, since three years have passed between the purchase and the sale, any cash flow from the sale must be discounted accordingly.
- At the time John Doe buys the house, the 3-year US Treasury Note rate is 5%. Treasury Notes are generally considered to be inherently less risky than real estate, since the value of the Note is guaranteed by the US Government and there is a liquid market for the purchase and sale of T-Notes. If he hadn't put his money into buying the house, he could have invested it in the relatively safe T-Notes instead. By not doing so, he has incurred an opportunity cost from his decision.
So, calculating exclusively for opportunity cost, we get a discount rate of 5% per year (taking the comparable-period Treasury rate of return directly). Using the DPV formula above, that means that the value of $150,000 received in three years actually has a present value of $129,576 (rounded off). Those future dollars aren't worth the same as the dollars we have now. Treasury Securities are bonds issued by the U.S. Federal Reserve. ...
Market liquidity is a business or economics term that refers to the ability to quickly buy or sell a particular item without causing a significant movement in the price. ...
The present value of a single or multiple future payments (known as cash flows) is the nominal amounts of money to change hands at some future date, discounted to account for the time value of money, and other factors such as investment risk. ...
Subtracting the purchase price of the house ($100,000) from the present value results in the net present value, which would be $29,576 or a little more than 29%. Amortized over the three years, that implies a discounted annual return of 8.6% (still very respectable, but only 63% of the profit he previously thought he would have). Note that the original internal rate of return (13.6%) minus the discount rate (5%) equals the discounted internal rate of return (8.6%). The discount rate directly modifies the annual rate of return. The present value of a single or multiple future payments (known as cash flows) is the nominal amounts of money to change hands at some future date, discounted to account for the time value of money, and other factors such as investment risk. ...
It has been suggested that this article or section be merged with Discounted cash flow. ...
But what about risk?
- The house John is buying is in a "good neighborhood", but market values have been rising quite a lot lately and the real estate market analysts in the media are talking about a slow-down and higher interest rates. There is a probability that John might not be able to get the full $150,000 he is expecting in three years due to a slowing of price appreciation, or that loss of liquidity in the real estate market might make it very hard for him to sell at all.
For the sake of the example, let's then estimate his risk factor is about 5% (we could perform a more precise probablistic analysis of the risk, but that is beyond the scope of this article). Therefore, this analysis should now include both opportunity cost (5%) and risk (5%), for a total discount rate of 10% per year.
Going back to the DPV formula, $150,000 received three years from now and discounted at a rate of 10% is only worth $112,697 (rounded off) in present-day dollars. The present-value profit on the sale is now down to $12,697 discounted dollars from $50,000 nominal dollars. The implied annual rate of return on that discounted profit is now 4.065% per year.
That return rate may seem low, but it is still positive after all of our discounting, suggesting that the investment decision is probably a good one: it produces enough profit to compensate for opportunity cost and risk with a little extra left over. When investors and managers perform DCF analysis, the important thing is that the net present value of the decision after discounting all future cash flows at least be positive (more than zero). If it is negative, that means that the investment decision would actually lose money even it appears to generate a nominal profit. For instance, if the expected sale price of John Doe's house in the example above was not $150,000 in three years, but $130,000 in three years or $150,000 in five years, then buying the house would actually cause John to lose money in present-value terms (about $6,000 in the first case, and about $9,000 in the second). Similarly, if the house was located in an undesirable neighborhood and the Federal Reserve Bank was about to raise interest rates by five percentage points, then the risk factor would be a lot higher than 5%: it might not be possible for him to make a profit in discounted terms even if he could sell the house for $200,000 in three years. Federal Reserve Districts The United States Federal Reserve System consists of twelve Federal Reserve Banks, each responsible for a particular district, and some with branches. ...
In this example, only one future cash flow was considered. For a decision which generates multiple cash flows in multiple time periods, DCF analysis must be performed on each cash flow in each period and summed into a single net present value. It has been suggested that this article or section be merged with Discounted cash flow. ...
Methods Depending on the financing schedule of the company four different DCF methods are distinguished today. Since the underlying financing assumptions are different they do not need to arrive at the same value of the project or company: - Equity-Approach
- Entity-Approach:
The Flows to Equity-Approach is one of three commonly used discounted-cash-flow (DCF) methods of corporate valuation, the other two are Adjusted Present Value and Weighted Average Cost of Capital (WACC). ...
The Adjusted Present Value (APV) is the Net present value (NPV) of a project if financed solely by ownership equity plus the present value (PV) of any financing benefits (the additional effects of debt). ...
The weighted average cost of capital (WACC) is used in finance to measure a firms cost of capital. ...
History Discounted cash flow calculations have been used in some form since money was first lent at interest in ancient times. As a method of asset valuation it has often been opposed to accounting book value, which is based on the amount paid for the asset. Following the stock market crash of 1929, discounted cash flow analysis gained popularity as a valuation method for stocks. Irving Fisher in his 1930 book "The Theory of Interest" and John Burr Williams's 1938 text 'The Theory of Investment Value' first formally expressed the DCF method in modern economic terms. Irving Fisher, 1927. ...
John Burr Willams (1899 - 1989) was a founder and developer of the fundamentalist theory of asset valuation [1], and was one of the first economists to view stock prices as determined by “intrinsic valueâ€. He is best known for his 1938 text The Theory of Investment Value, based on his...
John Burr Williams (1899 - 1989) was one of the first economists to view stock prices as determined by “intrinsic value†and, in this role, was a founder and developer of fundamental analysis [1]. He is best known for his 1938 text The Theory of Investment Value, based on his Ph. ...
See also The Adjusted Present Value (APV) is the Net present value (NPV) of a project if financed solely by ownership equity plus the present value (PV) of any financing benefits (the additional effects of debt). ...
The process of determining which potential long-term projects are worth undertaking, by comparing their expected discounted cash flows with their internal rates of return. ...
Economic Value Added (EVA) is an estimate of true economic profit after making corrective adjustments to GAAP accounting, including deducting the opportunity cost of equity capital. ...
The Flows to Equity-Approach is one of three commonly used discounted-cash-flow (DCF) methods of corporate valuation, the other two are Adjusted Present Value and Weighted Average Cost of Capital (WACC). ...
It has been suggested that this article or section be merged with Discounted cash flow. ...
The internal rate of return (IRR) is a capital budgeting method used by firms to decide whether they should make long-term investments. ...
A method for determining the current value of a company using future cash flows adjusted for time value. ...
The time value of money is the premise that an investor prefers to receive a payment of a fixed amount of money today, rather than an equal amount in the future, all else being equal. ...
The cost of capital for a firm is a weighted sum of the cost of equity and the cost of debt (see the financing decision). ...
External links
Literature - Tom Copeland, Tim Koller, Jack Murrin: Valuation. J. Wiley & Sons, 2nd edition, 1998.
- International Federation of Accountants, Project Appraisal Using Discounted Cash Flow (exposure draft), 2007
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