Understanding Discounted Cash Flow

What is DCF?

Discounted cash flow (DCF) is an analysis method that is used to value a company, project or asset. DCF applies the principles of time value of money and is helpful in estimating the attractiveness and viability of an investment. In this valuation method, the cost of capital is used in estimating and discounting all future cash flows to obtain their present values (PVs). Simply put, the value of the sum of the total incoming and outgoing cash is known as the net present value (NPV). DCF concept is common in the bond markets where stock analysts compute net future and present values to determine where and when itโ€™s best to invest money or withdraw cash. The analysis method is not uncommon in patent valuation, real estate development, and corporate finance. Also, the concept was widely used in the U.S. in the late 1980s and 1990s.

Small Businesses and DCF

Having been tried and tested for years, DCF is one of the best and simplest valuation methods. Small business owners in the U.S. can use the concept to determine the amount of money they should invest in their businesses, and ascertain if the ventures will be profitable or not. The process is simple and involves projecting unlevered future cash flows, choosing a discount rate, calculating the time value of money, discounting the project future cash flows and time value to get the NPV, and calculating the NPV from the FV to obtain the estimated profits.

Time value of money, which is the primary determinant in DCF, assumes that the value of a dollar today is more valuable than a dollar tomorrow. A good example is when a 100-dollar investment has a daily interest of 10 percent. This means that the small business owner will get a get a profit of $10 every day in addition to the $100 they invested.

By Moneypilot

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