What is discounted cash flow?

Financial investments are always a risk. You never really know what kind of return you’ll see in the coming years. The best we can do is make educated guesses based on projections and calculations. 

Discounted cash flow (DCF) is a useful part of those projections. It’s used by investors and business owners to help them make more accurate predictions about the future performance of their investments. 

But how exactly does it work in practice? 

In this guide, we’ll be discussing everything you need to know about discounted cash flow, including:

• What is discounted cash flow?
• Why does discounted cash flow matter to small businesses?
• How do I calculate discounted cash flow?
• The problems with discounted cash flow. 

It’s worth mentioning that this article is only about discounted cash flow and how it’s used. If you’d like more information about cash flow in general, then check out our articles, “What is free cash flow?” and “How to track cash flow”.

Discounted cash flow (DCF) is a key part of estimating the value of an investment, over time, based on its future cash flow. 

For example, if you’re looking to invest in a company, you’ll want to make projections about the return on investment you’ll see over the coming years. Although, things get a little tricky because the value of money decreases over time. In other words, £1 today is worth more than £1 in a year’s time. 

If the company you’re investing in will have a consistent cash flow of £100,000 every year, for the next three years, that looks great on the surface. £100,000 every three years means a total of £300,000.

Although, when we take inflation into account, that £300,000 is actually worth less than £300,000 in today’s money. That’s where discounted cash flow comes in.

Discounted cash flow aims to give you a more accurate idea of how much cash flow the company will see in today’s money. It’s giving you a true picture of the company’s performance by taking inflation into consideration. 

For small businesses, DCF matters for a number of reasons. 

First, it’s essential for figuring out whether certain long-term investments will be worthwhile over time. For example, you might want to invest in an expensive piece of equipment, or rent out a building for business. 

To figure out if the investment is a good idea, you can contrast what you’ll pay compared to the income it will generate during business operations. But remember, the value of that income will decrease every year, so applying discounted cash flow to the calculation can tell you the actual amount return you’ll see on the investment. 

On the other hand, if you’re looking for investors for your own company, discounted cash flow is useful for showing them how much cash flow you’re likely to see over time, in today’s money. 

For simplicity’s sake, let’s use the example we mentioned earlier. Imagine you’re trying to figure out the discounted cash flow of a company that you can expect a cash flow of £100,000 per year over the next three years. 

To find the discounted cash flow, we need to use this formula:

DCF = ((CF1) / (1+r)^1) + ((CF2) / (1+r)^2) + ((CF3) / (1+r)^3)

CF1 = Cash flow for the first year. 

CF2 = Cash flow for the second year. 

CF3 = Cash flow for the third year.

r = Discount rate.

We know the cash flow for each year, £100,000, so that part is easy. 

For our discount rate, we have to make another assumption. For the sake of the example, we could say it’s 10%, representing an yearly inflation rate of 10% (or 0.1)

When we start substituting these figures into the formula, it’ll look like this:

DCF = (100,000 / (1+0.1)^1) + (100,000 / (1+0.1)^2) + (100,000 / (1+0.1)^3)

Or

DCF = (100,000 / 1.1) + (100,000 / 1.21) + (100,000 / 1.33) 

Or 

DCF = 90,909.09 + 82,644.63 + 75,187.97

Or 

DCF = 248,741.69

From the formula, we can now see the discounted cash flow after three years is £248,741.69.

Now, we can see why using discounted cash flow is important for assessing company value. The actual value is vastly different from the figure we got before we used DCF (£300,000).

The main problem with applying discounted cash flow when measuring future returns is the number of assumptions you have to make when using the formula. 

No matter how accurately you use the formula we mentioned above, the figures used to get the final figures are all based on estimates. 

Both interest rates and future cash flow are impossible to know, so even the best accountant will be using a certain amount of guesswork. 

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