Discounted Cash Flow
(DCF)

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Converting future earnings to today's money. Explanation Discounted Cash Flow.

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Discounted Cash Flow (DCF) is, what amount someone is willing to pay today, in order to receive the anticipated cash flow of future years. The DCF method converts future earnings to today's money. The future cash flows must be recalculated (discounted) to represent their present values. In this way the value of a company or project under consideration as a whole is determined properly.


Discounted Cash Flow calculation

The DCF for an investment is calculated by estimating: the cash that you will have to pay out, and the cash which you expect to receive back. The timeframes that you expect to receive the payments must also be estimated. Each cash transaction must then be recalculated, by subtracting the opportunity cost of capital between now and the moment when you will pay or receive the cash.


DCF example

For example, if inflation is 6%, the value of your money would halve every ±12 years. If you expect that a particular asset will provide you an income of $30.000 in 12 years from now, that income stream would be worth $15.000 today if inflation was 6% for the period. We have now discounted the cash flow of $30.000: it is only worth $15.000 for you at this moment.
 

Why Discounted Cash Flow?

The DCF method is an approach for valuation, whereby projected future cashflows are discounted at an interest rate (also called: Rate of Return), that reflects the perceived amount of risk of the cash flows. In fact, the discount rate reflects two things:

  1. The time value of money. Any investor would prefer to have cash immediately than having to wait. Therefore investors must be compensated by paying for the delay.
  2. A risk premium that represents the extra return which investors demand, because they want compensation for the risk that the cash flow might not materialize.

History of DCF

Discounted Cash Flow was first formally articulated in 1938 in a text by John Burr Williams: 'The Theory of Investment Value'. This was after the market crash of 1929 and before auditing and public accounting were mandated by the SEC. Understandably, as a result of the crash, investors were wary of relying on reported earnings, or in fact any measures of value apart from cash. Throughout the 1980s and 1990s, the value of cash and physical assets gradually became less well correlated with the total value of the company (as determined by the stock market). According to some estimates, tangible assets dropped towards less than one-fifth of the total corporate value. Intangible assets, such as customer relationships, patents, proprietary business models, channels, etc., are the remaining four-fifths.


Book: S. David Young, Stephen F. O'Byrne - EVA and Value-Based Management: A Practical Guide.. -

Book: Aswath Damodaran - Investment Valuation: Tools and Techniques for Determining Value.. -

Book: James R. Hitchner - Financial Valuation: Applications and Models -




Discounted Cash Flow Forum (9 topics) Help
  What is Discounted Cash Flow? (DCF)
DCF shows the future cash inflows at a discounted rate.
In simple terms, DCF tells us about how much our future inflows are worth at the present.
Background: the money that we have today will lose its value in the future. The value of futur...
     
  DCF Simple but has Weaknesses!
The DCF method is the simplest in use, but is a complete failure in measuring uncertainty and risk, so simulation and the real options method hold the key for those situations......
     
  Asset Pricing Model versus DCF
The DCF valuation is done on present value with no depreciation considered. In fact asset pricing is done on future application of product usage. Like a motor buying on a second usage....
     
  DCF Method versus CAPM Model
What are the differences between discounted cash flow methods and capital asset pricing model?...
     
  Advising Finance and Small Business
If you are a financial advisor to small businesses, please don't try to use investment theory when explain how they should manage business cash flow. You will end up with zero result. But this is what you CAN do:
First take all his revenue and t...
     
  Why Cant We Treat it as Capital Budgeting
Payback and NPV analysis share the same logic. So what is the difference between capital budgeting models and discounted cash flow?...
     
  DCF vs Present Value
Can someone please explain the difference between the Discounted Cash Flow (DCF) and Present Value (PV)?...
     
  How to Use DCF for Designing Executive's Compensation Package/Salary
How can one use DCF for fixing the salary package for executives to be employed in an organisation....
     
  DCF for Capital Projects in Condo Association
QUESTION: Hi, Condo association is planning roof replacement ten years from now. Today estimations are $1M. Should discounting be applied to this project? It means that future cost of the project would be 1M/(1+disc. rate)^10. Is it correct? ...
     



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Residual Income, EVA and DCF - Valuation
Introduction to Discounted Cash Flow - Initial Understanding of DCF
How to Calculate NPV in MS Excel - Basic Understanding of how to use Excel for calculating NPV
 

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Compare with Discounted Cash Flow: Net Present Value  |  Payback Period  |  IRR  |  Management Buy-out  |  Economic Margin  |  Relative Value of Growth  |  Total Cost of Ownership  |  CAGR  |  Cost of Equity


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