What is Discounted Cash Flow (DCF)?

Discounted Cash Flow (DCF) is a method used to determine the value of an investment or business based on its future cash flows, adjusted for the time value of money.

Discounted Cash Flow (DCF) is a method used to determine the value of an investment or business based on its future cash flows, adjusted for the time value of money. In simpler terms, it’s about figuring out how much money an investment will make in the future but adjusting for the fact that money today is worth more than the same amount in the future.

The Time Value of Money

Money has a time value because, over time, you can invest or use money in various ways to generate more. For example, Rs 100 today can earn interest, but Rs 100 a year from now won’t have the same buying power. This is why when valuing future cash flows, we need to discount them back to today’s value.

How Does DCF Work?

1. Estimate Future Cash Flows: This is the amount of money you expect the investment to generate in the future.
2. Choose a Discount Rate: The discount rate reflects the risk and return expectations. A higher rate is used for riskier investments.
3. Discount the Future Cash Flows: This means adjusting future money to its value today using the discount rate.
4. Add Them Up: Finally, the sum of all discounted future cash flows is the present value of the investment.

Simple Example

Let’s say you’re thinking about investing in a small business, and you want to know how much it’s worth today using the DCF method.

Step 1: Estimate Future Cash Flows

Imagine that you expect the business to generate the following cash flows for the next three years:

• Year 1: Rs 10,000
• Year 2: Rs 12,000
• Year 3: Rs 15,000

Step 2: Choose a Discount Rate

Let’s use a discount rate of 10 per cent. This rate reflects your expected return and the risk of the investment.

Step 3: Discount the Future Cash Flows

We need to adjust these future cash flows to their present value using the formula:

Step 4: Add Them Up

Now, add the discounted values together to get the total present value: Rs 9,090.91 + Rs 9,917.36 + Rs 11,268.06 = Rs 30,276.33

So, the DCF value of the business today is Rs 30,276.33.

What Does This Mean?

This means that if you were to buy the business today, its future cash flows (after being adjusted for the time value of money) are worth about Rs 30,276.33. If the business is for sale for less than this amount, it might be a good deal. If it’s for more, it could be overpriced based on these cash flow projections.

Summary

DCF helps investors make decisions by valuing future cash flows today. It adjusts future earnings to account for the time value of money and provides a clearer idea of how much an investment is worth. By estimating cash flows, selecting a discount rate, and doing some math, you can determine if an investment is a good one.

Disclaimer: The article is for informational purposes only and not investment advice.