A discounted cash flow analysis incorporates the time value of money concept in order to find the net present value of a planned project, asset or investment. For business owners looking to make capital or financial investments or begin a new project, discounted cash flow tables illustrate whether or not these activities will be profitable over time. To understand discounted cash flow valuation, you must first understand the time value of money concept.
The time value of money concept is simply taking future cash flows and discounting them to their present value (PV). An easy way to remember this concept is this: One dollar today buys you more than one dollar will ten years from today. Here is how the financials represented in discounted cash flow models are key in helping business owners determine which capital or financial investment is more profitable:
1. Discounted cash flow tables allows the investor to see if the investment will return positive or negative future cash flows over the life of the investment.
2. A positive net present value (NPV) of potential future discounted cash flows represents a relatively good investment.
3. A negative net present value of potential future discounted cash flows represents a potentially poor investment or at the very least, a riskier investment.
Get the discounted rate by calculating the present value (PV) of future cash flowsTo get a fairly accurate discounted rate, the formula is as follows: Interest rate divided by (1 + interest rate). So, if the interest rate is 10 percent, then the equation is .10/(1+.10)=.0909.
Compare multiple investments via discounted cash flow tablesWhen making a decision between multiple investments, you need to determine which one is the most beneficial. There are many software programs available that allow you to compare multiple investments using discounted cash flow techniques.
Determine the weighted average cost of capital (WACC) in the DCF analysis in order to assess riskUse the WACC in discounted cash flow analysis as a means of valuing a company by comparing its debt to its equity. This number gives you a minimum return rate of your capital or financial investment in order for it to be profitable.
- The biggest shortcoming of relying solely on discounted cash flow models is when the assumption inputs go into perpetuity. The longer the time assumption inputs into a discounted cash flow calculator, the less accurate the outputs. It's always best to put a definitive time line on these assumptions to get a more accurate analysis.