Discounted Cash Flow
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Insights on the Discounted Cash Flow Calculation
What is the goal of Discounted Cash Flow analysis?
Discounted cash flow analysis finds the present value of expected future cash flows using a discount rate. Investors can use the concept of the present value of money to determine whether the future cash flows of an investment or project are greater than the value of the initial investment.
What are the advantages?
Discounted cash flow analysis can provide investors and companies with an idea of whether a proposed investment is worthwhile. It is analysis that can be applied to a variety of investments and capital projects where future cash flows can be reasonably estimated. Its projections can be tweaked to provide different results for various what if scenarios. This can help users account for different projections that might be possible.
What are the disadvantages?
The major limitation of discounted cash flow analysis is that it involves estimates, not actual figures. So, the result of DCF is also an estimate. That means that for DCF to be useful, individual investors and companies must estimate a discount rate and cash flows correctly.
How Do You Calculate DCF?
Calculating the DCF involves three basic steps. One, forecast the expected cash flows from the investment. Two, select a discount rate, typically based on the cost of financing the investment or the opportunity cost presented by alternative investments. Three, discount the forecasted cash flows back to the present day, using a financial calculator, a spreadsheet, or a manual calculation.
Is Discounted Cash Flow the Same as Net Present Value?
No, it's not, although the two concepts are closely related. NPV adds a fourth step to the DCF calculation process. After forecasting the expected cash flows, selecting a discount rate, discounting those cash flows, and totaling them, NPV then deducts the upfront cost of the investment from the DCF.
