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Discounted Cash
Flow (DCF) is what someone is willing to pay today in order to receive
the anticipated cash flow in future years. DCF means
converting future earnings to today's money.
The future cash flows must be discounted
in order to express their present values in order to properly determine the
value of a company or project under consideration as a whole.
The DCF for an investment is
calculated by estimating the cash you will have to pay out and the cash you
think you will receive back. The times that you expect to receive the
payments must also be estimated. Each cash transaction must then be
discounted by the opportunity cost of capital over the time between now and
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 are expecting an asset to give you an income of $30.000 a year in 12
years time, that income stream would be worth $15.000 today if inflation
was 6% for the period. We have just
discounted the cash flow of $30.000: it's only worth $15.000 to you at this
moment.
The DCF method is an approach to valuation, whereby projected
future cashflows are "discounted"
at an interest rate (also called: "rate of return"), that reflects the
perceived riskiness of the cashflows. The discount rate reflects two things:
1. the time value
of money (investors would rather have cash immediately than having to
wait and must therefore be compensated by paying for the delay)
2. a risk premium
that reflects the extra return investors demand because they want to be
compensated for the risk that the cash flow might not materialize after
all.
History: Discounted cash flow was first formally articulated in John Burr
Williams' 1938 text 'The Theory of Investment Value' after the market crash
of 1929 and before auditing and pubic accounting were mandated by the SEC.
As a result of the crash, investors were wary of relying on reported income,
or indeed, any measures of value besides cash. Throughout the 1980s and
1990s, the value of cash and physical assets became steadily less well
correlated with the total value of the company (as determined by the stock
market). By some estimates, tangible assets dropped to less than one-fifth
of corporate value (intangible
assets such as customer relationships, patents, proprietary business
models, channels, etc. comprising the remaining four-fifths).
Book: S. David Young, Stephen F. O'Byrne - EVA and Value-Based Management:
A Practical Guide to Implementation -
Book: Aswath Damodaran - Investment Valuation: Tools and Techniques for
Determining the Value of Any Asset -
Book: James R. Hitchner - Financial Valuation:
Applications and Models -
Compare with
Discounted Cash Flow:
Net Present Value |
Payback Period |
IRR |
Management buy-out
|
Economic Margin
More valuation methodologies
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