What is Discounted Cash Flow (DCF)?
Discounted cash flow, or DCF, is one approach to valuing a business, by calculating the value of its future cash flow projections. The key to understanding this, however, is the concept that money in the future is not worth as much as that same money today. That’s referred to as the time value of money.
To calculate what a certain amount of money is worth in the future, you have to discount it, or account for the fact that you lost the chance to invest it and earn money from it. Hence, why it is called the discounted cash flow method.
To illustrate the point, let’s say that your company made $10,000 today. That $10,000 today is worth more than $10,000 a year from now, or five years from now. That’s because you could invest today’s $10,000 and earn interest that would increase the total amount after a year. At an interest rate of 5%, in a year that $10,000 would grow to be worth $10,500. Obviously, $10,500 is worth more than $10,000.
But what is $10,000 in a year worth today? Fortunately, there’s an equation for that.
To calculate DCF, or what a certain amount of future money is worth today, you use this:
DCF = Cash flow/ (1 + current interest rate) years in the future
In this example, you would take: $10,000/(1 + .05)1. And $10,000/1.05 = $9,523.81.
That means that the value of $10,000 a year from now, at a 5% interest rate, is $9,523.81.
The future value of $10,000 in two years is even less - $9,070.29. The farther out you go, the less you should pay for that $10,000.
Valuing a Company
So let’s apply that now to determining the value of a company you may be interested in buying, or maybe if you were considering selling your own. It’s important to factor in the value of the future cash flow the company will generate. If the is expected to earn $2 million this year, that doesn’t meant that you should pay $2 million for it. You would be paying too much.