Discounted cash flow is a method of estimating the value of something based on how much money it is expected to generate in the future.
discounted cash flow
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What is discounted cash flow?
How is discounted cash flow used?
How does discounted cash flow work?
What is the discounted cash flow formula?
Benefits and limitations of discounted cash flow
Frequently Asked Questions About Discounted Cash Flow
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When someone in the United States buys a lottery ticket, they usually know that the prizes are paid to winners in equal annual installments over a long period of time.
What many don't know, perhaps because it appears in the fine print under the large sum, is the smaller amount that the winner could receive immediately, without waiting for future installments. That amount is known as the cash option, or the current cash value of the advertised prize.
How does the lottery determine the value of this canadian email address list cash option? It calculates how much each annual payment is worth today, based on an assumed interest rate and the number of years until all annual payments are made. This process is called discounting future values, or discounting cash flows.
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What is discounted cash flow?
Discounted cash flow is a method of calculating the current value of something—a company's stock, a rental property, or any other income-producing asset—based on how much money the asset is expected to generate in the future.
Future discounted cash flow is based on a fundamental concept in modern finance: the time value of money. This means that money increases in value over time because it can be invested to earn interest.
Therefore, 100 euros today are worth more than 100 euros in a year. For example, at an annual interest rate of 5%, 100 euros now will become 105 euros in a year. In the coming years, the amount will grow even faster due to what is known as compounding, which can be understood as interest earned on interest.
Here is an example of compounding based on 100 Euros earning 5% annual interest for three years. The interest rate is expressed as 0.05 with the constant 1, or 1.05:
€100 x 1.05 x 1.05 x 1.05 = €115.76 capitalized value
You can think of discounting as the opposite of compounding. Whereas compounding starts with money right now and calculates how it grows over time through reinvestment of the principal and interest, discounting does the opposite: it projects a sum of money into the future and progressively reduces it through the same compounding process down to the present value, i.e. the discounted value.
Let's take as an example someone who is going to receive 100 euros in three years. If the expected annual interest rate is 5%, the calculation would be done as follows:
€100 ÷ 1.05 ÷ 1.05 ÷ 1.05 = €86.38 discounted value
So 100 euros in three years is worth 86.38 today.
There are other ways to think about discounted cash flows. For example, how many small investors have said to themselves: “I want to have 1 million euros in 10 years. How much money do I need now to grow it to 1 million, assuming I can earn 5% per year?”
Discounting 1 million euros at a rate of 5% capitalized over 10 years, or 1.05 raised to the tenth power, we obtain 1.62889 and the calculation would be:
€1,000,000 ÷ 1.62889 = €613,915 discounted cash flow
So a small investor could start with €613,915 and let it grow at 5% annual interest compounded over 10 years, thus reaching €1 million.
How is discounted cash flow used?
The primary purpose of discounted cash flow is to determine the theoretical value or price for an asset, such as the appropriate stock price for a company. Comparing the discounted cash flows generated by a business to the stock price can help an investor evaluate whether the company is overvalued or undervalued.
For example, if a company's expected cash flows are discounted to give a theoretical value per share of €125 and the shares are trading at €110, an investor might conclude that the company is undervalued and that it is a good buying opportunity.
Discounted cash flows can also be used in other ways, such as determining a fair price for income-producing properties (rental apartments, office buildings), or valuing bonds or loans that might be traded. Discounted cash flow can also be used in cost-benefit analysis of proposed projects or business investments.
How does discounted cash flow work?
The discounting process begins with a series of estimated cash flows over future periods, usually years. A discount rate is then assumed. In the case of stocks, the discount rate is typically the company's weighted average cost of capital, or the rate of return sought by shareholders.
The average cost of capital is determined by the company's mix of debt and equity, as well as the proportional interest rates that must be paid on each.
Each cash flow is reduced by the discount rate raised to the power of the time period. For example, the second period cash flow would be reduced by the discount rate squared, the third period cash flow would be reduced by the discount rate cubed, and so on.
After discounting the cash flows for each period, they must be added together. In the case of stocks, a global total is included for the estimated cash flow in future years, called the terminal value. The total of all these discounted cash flows can serve as a theoretical price per share or asset.
Terminal value typically represents the majority of total discounted cash flows, and can vary based on the estimate of terminal value duration—the estimate of a company's useful life beyond the initial discount years. For example, one financial analyst may estimate a 10-year useful life for terminal value, while another might estimate 20 years.
Many financial analysts and fund managers take the discounting process one step further. They use a higher growth rate for the company in its early years, followed by a lower rate for the terminal value years. This makes discounted cash flow analysis more sophisticated, but also more complex because it uses two different rates.