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
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.
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:
- 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.
- A risk premium that represents the extra return which investors
demand, because they want compensation for the risk that the cash flow might
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 -
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