Keeping tabs on your cash flow is so important when evaluating the health of your business, because the cash flow you have today isn’t exactly what you can expect a quarter, year, or even decade from now.
So, how can you forecast with so many factors—including inflation—to consider? Enter the discounted cash flow (DCF) formula, which tells you the expected value of a business based on future cash flows. Let’s dive into what discounted cash flow is, how to calculate it, and why you need it.
What is the discounted cash flow (DCF) formula?
Okay, we know this formula looks super scary, but don’t worry! We’ll walk you through it, step by step. In a nutshell, the discounted cash flow formula uses expected cash flows and a discount rate to give you the estimated value of a business or investment.
Cash flow: Cash flow for the given year. Cash flow refers to the money moving in and out of your business. But we will focus on the net cash flow which is the net of inflows and outflows.
Cash flow 1: Cash flow for the first year.
Cash flow 2: Cash flow for the second year.
Cash flow n: The period number. Time periods can be years, quarters, months, etc.
r: The discount rate. The discount rate is used to find the present value of future cash flows. You’ll have to do some research to determine the appropriate discount rate for your calculation—it shouldn’t be lower than the inflation rate.
What is discounted cash flow (DCF)?
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. For example, discounted cash flow can give you insight into whether you 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.
Thanks to inflation, the value of a dollar changes every year (sigh). If you have $10,000 today, it’s going to be worth a different amount 100 years from now. That's why your grandpa can talk about going to the movies for $0.50 “back in the day,” while it cost you $18 last weekend.
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 typically 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.
Key takeaways: Discounted cash flow formula
DCF helps you estimate the value of your business based on future cash flows.
You need to determine the discount rate to find the present value of projected cash flows.
The DCF can help you make important business decisions, and may be of interest to any investors you have.
What is the time value of money?
Time value of money (TVM) is the concept that the 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 DCF model is based on.
What is the discounted cash flow (DCF) formula used for?
The discounted cash flow formula tells you more than just the 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 return on investment (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.
Here are some more reasons you might use the DCF:
To value your business
To value a project or something that impacts cash flow within your business
To value shares in your business
How do you calculate discounted cash flow (DCF)?
Calculating your discounted cash flow can be broken down into three parts.
First, choose your time periods and predict the cash flows of your business. You’ll want to consider things like how much money your business is expecting to receive and how much money your business will need to spend, as well as any known market trends and future operations in your business.
Then, use your best judgment to choose a discount rate. As we mentioned before, weighted average cost of capital (WACC) is the most common.
Now, get the calculator out and plug your numbers into the discounted cash flow formula. Use the discount rate to discount the cash flows to the current period.
If you’re confused, don’t freak out—an example is incoming.
Discounted cash flow (DCF) calculation example
Let’s say you’re the owner of a pet salon. You want to calculate your DCF to 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:
With a DCF of $33,576, the discounted cash flow is worth more than the initial investment of $30,000 in today's dollars.
Limitations of the discounted cash flow (DCF) formula
While the discounted cash flow formula is super valuable, there are also some pitfalls.
For one, the DCF model 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.
What is terminal value(TV)?
If you’re calculating your discounted cash flow, then you’ll probably be interested in your terminal value (TV). TV is the estimated value of your business beyond a specific forecasted period. It’s usually used as part of the discounted cash flow model. After using the discounted cash flow formula, you would then calculate the terminal value for the end of that period. TV can be another data point to help you analyze the total value of your business or investment.
Is DCF the same as net present value (NPV)?
Net present value (NPV) is used to analyze the current value of future cash flows over time within your business; it tells you how much the cash you make in the future is currently worth.
At first, net present value may sound like the same thing as discounted cash flow. However, while NPV contrasts the value of cash in the present day to the value of cash in the future, DCF focuses more on the value of investing and the future of your business. You can always use both of them together if you want to bolster your analysis.
Moving forward with discounted cash flow (DCF) formula
Discounted cash flow is a valuable tool to help you understand your business’s financial status both now and in the future. While it might look a little scary at first, it’s helpful in determining which investments are viable and can help you plan for the future of your small business.
If you need personal help using the discounted cash flow formula (or with any accounting-related matter, for that matter), you can book a call with one of Wave’s trained accounting coaches.
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