Discounted cash flow (DCF): How to calculate it

Discounted cash flow, or DCF, is a type of financial analysis used to understand the true value of your business or investments over time based on expected future profits. Calculating DCF involves projecting future cash flows using a discount rate to adjust them to the current value. By determining the present value of future earnings, DCF can help you make informed decisions about potential investments.

Keep reading to learn more about DCF, how to calculate it, its pros and cons and more.

What you’ll learn:

• Discounted cash flow (DCF) helps businesses and investors estimate the value of an investment based on projected cash flows.
• DCF is calculated using a formula that discounts projected future cash flows to their present value, generally using the weighted average cost of capital (WACC) as the discount rate.
• There are pros and cons to DCF analysis—it can help you determine if an investment is worth the effort, but it also carries the risk of overestimating or underestimating future cash flows.
• DCF shares similarities with other financial metrics like net present value (NPV) and adjusted

Analyzing DCF can help business owners or investors understand how much their business or investment today could be worth in the future. DCF uses a projected discount rate, which accounts for the fact that, due to economic factors like inflation, money loses value over time. It takes the future cash you expect to receive and adjusts it to reflect today’s value.

DCF can be especially helpful when you’re comparing different types of investment opportunities. You can determine which projects could offer the best return and ensure resources are allocated more effectively.

When strategizing potential options to expand your business, calculating DCF can help you make smarter financial decisions. If the DCF calculation shows a higher value today over what the investment initially cost, the opportunity may be worth pursuing. But if it’s worth less, you might want to reconsider.

In other words, if you’re considering spending money now to upgrade equipment or expand your team, will it lead to more revenue in the future?

DCF calculations use a variety of data. The weighted average cost of capital (WACC), which is your business’s average after-tax cost of capital from all sources and represents the number you expect to pay to finance your business, is generally used as the discount rate in the DCF formula. It also considers the time value of money (TVM), which means that money earned in the present is worth more than an identical amount earned in the future.

When calculating DCF, it’s important to first understand your business’s financials and the potential outcomes of the investment you’re considering. Properly managing your current cash flow helps you assess the overall financial health of your business. You’ll also gain a clearer understanding of your potential profitability and how the investment can help fuel future growth.

The formula to calculate DCF is as follows:

Here’s what each component of the DCF formula means:

• DCF = The total of all future projected discounted cash flows 

• CF1 = Cash flow for year one

• CF2 = Cash flow for year two

• CFn = Cash flow for additional years

• r = Discount rate, which can be based on the cost to finance the investment

Say your company needs to invest $150,000 in new equipment that could make processes more efficient over a three-year timespan. If the discount rate—the r in the DCF formula—is 6%, the projected cash flows would be as follows:

You’ll add up the total DCF results to get a value of $351,264. Then, subtracting your initial investment of $150,000, you’ll get a net present value (NPV) of $201,264. This means the investment in the new equipment could be well worth the initial cost. 

Here’s another example of how the DCF and NPV could change if the discount rate is 12% instead of 6%:

In this scenario, the total DCF value is $311,361. Subtracting the initial investment of $150,000 gives an NPV of $161,361. So while the investment still results in a profit, the margin is much smaller compared to the lower discount rate. This could make it a riskier investment for your company.

By running different scenarios with varying discount rates and cash flow projections, you can evaluate risks and better prepare for potential financial challenges, helping you to make more strategic decisions.

Whether you’re investing in new equipment or launching a new product, DCF can help you determine if that investment is worth the expense. It also allows you to easily see if the long-term returns will outweigh the initial cost.

DCF analysis is a detailed method that allows you to better understand your business’s potential growth, including gross margins and gross profits, based on the investments you make.

Analyzing different investment opportunities helps you better understand the potential outcomes of various scenarios. For example, if you’re deciding between opening a new location or investing in new equipment, DCF can help you compare the expected returns and results of both options to make the best decision.

DCF is based on assumptions and estimates, which may not always be accurate. Estimating cash flows and the discount rate correctly can be challenging, and errors in these inputs can affect the DCF results. For instance, overestimating your cash flow could lead to bad financial decisions, while underestimating it might cause you to overlook the growth potential a new investment or opportunity could bring to your business.

Factors like the economy, competition and market demand can all impact future cash flow. And it can be challenging to accurately determine the impact these factors will have when calculating DCF.

DCF analysis isn’t the only valuation method your business can use to project future cash flows. Here’s a look at how DCF compares to other financial metrics:

• Net present value (NPV): Similar to DCF, NPV uses projections and discount rates to project future cash flows. However, NPV also subtracts the initial investment cost from the discounted cash flow, while DCF doesn’t deduct up-front costs. 

• Adjusted present value (APV): A key difference between APV and DCF is that the APV method doesn’t use a discount rate like WACC, which includes taxes and financing costs. Instead, APV values the project or business as if it were entirely equity funded—without any debt—and then adds back the benefits of financing separately. 

• Internal rate of return (IRR): IRR is a measurement used to estimate the profitability of a potential investment. The main difference between IRR and DCF is how they evaluate an investment’s value. Unlike DCF, which helps a business determine whether the investment is worth the cost, IRR explains the expected percentage return on the investment.

• Free cash flow (FCF): FCF is the actual cash a business generates after paying operating expenses and capital expenditures. It reveals whether the company is making enough money after those expenses to satisfy investors, creditors or reinvestment needs, reflecting the business’s financial health and flexibility. DCF uses the projected FCF to estimate the present value of an investment to help determine whether the investment is worth the cost.

DCF helps you estimate the present value of your business or an investment. It adjusts expected future cash flows to reflect their present value using a discount rate that factors in inflation and other variables. This method can help you understand the time value of money and make wise investment decisions.

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