The discounted cash flow method
/What is the Discounted Cash Flow Method?
The discounted cash flow method is designed to establish the present value of a series of future cash flows. Present value information is useful for investors, under the concept that the value of an asset right now is worth more than the value of that same asset that is only available at a later date. An investor will use the discounted cash flow method to derive the present value of several competing investments, and usually picks the one that has the highest present value. The investor may not pick an investment with the highest present value if it is also considered a riskier opportunity than the other prospective investments.
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The Calculation of Discounted Cash Flow
The steps to be taken to calculate present value under the discounted cash flow method are as follows:
Itemize all positive and negative cash flows associated with an investment. This can include the following:
The initial purchase
Subsequent maintenance on the initial purchase
The working capital investment associated with the initial purchase
The profit on sales of the goods and services derived from the investment
The amount of income tax sheltered by the depreciation on the acquired asset
The working capital reduction that occurs once the asset is later sold
The salvage value of the asset that is expected when it is sold at the end of its useful life
Determine the cost of capital of the investor. This is the after-tax cost of the investor's debt, preferred stock, and common stock. It may also be adjusted upward to account for the additional risk associated with an investment. The cost of the investor's common stock is the most expensive and difficult to calculate.
Plug the cash flows from Step 1 and the cost of capital from Step 2 into the following calculation to derive the present value of all cash flows:
Net present value = X × [(1+r)^n - 1]/[r × (1+r)^n]
Where:
X = The amount received per period
n = The number of periods
r = The required return (cost of capital)
The preceding formula can be plugged into the Excel electronic spreadsheet to arrive at the discounted cash flow figure.
Advantages of the Discounted Cash Flow Method
Ultimately, one of the best ways to determine the value of an asset is to derive the discounted cash flows associated with it. This is a highly quantitative approach to determining value, as opposed to a variety of qualitative methods that tend to overvalue assets. At a minimum, an asset analysis should always include a review of discounted cash flows, even if other valuation methods are being used as well.
Disadvantages of the Discounted Cash Flow Method
There are several concerns with using the discounted cash flow method, not least of which is the difficulty of deriving accurate estimates for it. The person conducting the analysis might estimate cash inflows and outflows too high or too low, or may not use a valid discount rate. The result can be inordinately positive or negative outcomes that make the analysis useless for decision-making purposes.
Discounted Cash Flow vs. Net Present Value
Net present value is not quite the same as discounted cash flow. The discounted cash flow method is used to derive the current-day value of a stream of future cash flows, while net present value also subtracts out the upfront cost of the investment that triggers that stream of future cash flows, to decide whether the investment is a good idea. For example, a discounted cash flow method might indicate that a stream of future cash flows has a present value of $5,000, while a net present value analysis would go one step further and subtract the $4,500 cost of the initial investment, resulting in a $500 net present value that incorporates all aspects of the investment.