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Discounted Cash Flow Formula

Cash flow is so important to day-to-day business operations. It’s what you use to pay employees, vendors, and suppliers. It’s how customers pay you for your products and services. It’s how you keep the lights on in your storefront. It’s how you earn interest on investments.

But the cash flow you have today isn’t exactly the same as what you can expect a quarter, year, or even decade from now.

Thanks to inflation, the value of a dollar changes every year. If you have $10,000 today, it’s going to be worth a different amount 100 years from now.

So, how can you forecast with so many factors to consider? Enter discounted cash flow. Let’s dive into what discounted cash flow is, why you need it, and how to calculate it.

What is discounted cash flow?

Discounted cash flow is a measure of anticipated cash flow. These cash flow projections give a forward-looking view into a business’s cash flow. Discounted cash flow (DCF) gives a business owner insight into whether they can afford to make a larger purchase or investment now and be able to pay it off later.

Simple so far, but here’s where it gets a little tricky: that amount of projected cash flow isn’t equal to the same amount of cash today.

Look at it this way: $1 was worth a lot more in 1800 than it is today. In fact, $1 in 1800 would be equivalent to $20.38 in 2019.

When you calculate DCF, you look at the current value of projected cash flow. To do so, the calculation applies a discounted rate per accounting period. This rate is based on the weighted average cost of capital (WACC), which is the average cost the company pays for capital to finance assets, whether from selling equity or borrowing money.

What is time value of money?

Time value of money (TVM) is what we just described: the concept that the numerical measure of cash available to a business today is of greater value than that same number in future accounting periods. In other words, the earlier you receive money, the more it’s worth. This is what the idea of DCF is based on.

Why calculate discounted cash flow

DCF tells you more than just future value and cash flow of a company. It can also indicate whether an investment is worth making or not. In fact, this is the most common use case for the DCF calculation.

For example, if you pay a price lower than the DCF value, you’ll generate a positive ROI from your investment. On the flip side, if you pay more than the DCF, you’ll lose money — a sign of a bad investment.

Like other accounting metrics, lenders and investors may also look at discounted cash flow to determine the financial viability of a business. Lenders want to make sure they’ll get paid, and investors want to make money from their investment. A healthy DCF is a good sign for both of those.

How to calculate discounted cash flow

The formula for DCF goes like this:

Discounted cash flow = (cash flow period 1 / (1 + interest or discount rate)1) + (cash flow period 2 / (1 + interest or discount rate)2) + … + (cash flow period n / (1 + interest or discount rate)n)

Abbreviated, it looks like this:

DCF = (CF1 / (1 + r)1) + (CF2 / (1 + r)2) + … + (CFn / (1 + r)n)

This depends on the number of periods you’re projecting cash flow for.

Discounted cash flow example

As we mentioned before, calculating DCF can help you evaluate potential investments and determine if they’ll deliver a positive ROI.

Let's say you have $30,000 to invest, and you’re offered the opportunity to invest in a company which is expected to pay dividends of $5,000 per year over the next 10 years. The discount rate is 8%, because in this case, it's the return that you could get if you invested in an index fund.

To calculate future cash flows, you’ll use the DCF formula:

DCF = (CF1 / (1 + r)1) + (CF2 / (1 + r)2) + … + (CFn / (1 + r)n)

Now let’s plug and play:

DCF = ($5,000 / (1 + 8%)1) + ($5,000 / (1 + 8%)2) + ($5,000 / (1 + 8%)3) + ($5,000 / (1 + 8%)4) + ($5,000 / (1 + 8%)5) + ($5,000 / (1 + 8%)6) + ($5,000 / (1 + 8%)7) + ($5,000 / (1 + r)8) + ($5,000 / (1 + 8%)9) + ($5,000 / (1 + 8%)10)

This becomes:

DCF = ($5,000 / (1.08)1) + ($5,000 / (1.08)2) + ($5,000 / (1.08)3) + ($5,000 / (1.08)4) + ($50,000 / (1.08)5) + ($5,000 / (1.08)6) + ($5,000 / (1.08)7) + ($5,000 / (1.08)8) + ($5,000 / (1.08)9) + ($5,000 / (1.08)10)

And then:

DCF = ($5,000 / 1.08) + ($5,000 / 2.16) + ($5,000 / 3.24) + ($5,000 / 4.32) + ($5,000 / 5.40) + ($5,000 / 6.48) + ($5,000 / 7.56) + ($5,000 / 8.64) + ($5,000 / 9.72) + ($5,000 / 10.80)

Next step:

DCF = $4,629.63 + $2,314.81 + $1,543.21 + $1,157.47 + $925.93 + $771.60 + $661.38 + $578.70 + $514.40 + $462.96

And finally:

DCF = $13,560.09

Phew!

With a DCF of $13,560.09, the discounted cash flow is worth less than the initial investment of $30,000 in today's dollars.

Drawbacks of discounted cash flow

While DCF is super valuable, there are also some pitfalls.

For one, the DCF formula assumes accuracy in forecasting. And we all know that while you can forecast pretty accurately, nothing in the future is guaranteed: sales, inflation, the economy, etc.

Similarly, the DCF formula doesn’t account for any external or uncontrollable variables. Brick-and-mortar retailers, for example, typically see less foot traffic on rainy days and thus make fewer sales. Likewise, if you’re a ski instructor, lots of snow will likely make for a busier-than-normal season.

So while DCF is certainly valuable and worth a calculation, it’s important to understand it’s not 100% accurate and may fluctuate. Take these metrics with a grain of salt.

Moving forward with discounted cash flow

Discounted cash flow is a valuable metric to help you understand your business’s financial status both now and in the future. Though it can be complicated to calculate, it’s helpful in determining which investments are viable and how much you can plan for in the future.

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