Discounted cash flow: Formula, calculation and business use
Learn how discounted cash flow helps you value your business and projects, and how to calculate it.
Written by Lena Hanna—Trusted CPA Guidance on Accounting and Tax. Read Lena's full bio
Published Wednesday 19 November 2025
Table of contents
Key takeaways
• Apply the three-step DCF calculation process by forecasting future cash flows, selecting an appropriate discount rate based on your cost of capital, and converting those projections into present value using the DCF formula.
• Use DCF analysis to evaluate major business decisions such as equipment purchases, market expansions, new product launches, or acquisitions by comparing the net present value across different investment options.
• Focus DCF analysis on projects with predictable cash flows and clear timelines, while avoiding its use for highly unpredictable ventures or early-stage businesses with limited financial history.
• Interpret your results by checking if the net present value is positive, which indicates the investment will generate more than your initial cost and suggests the project is financially viable.
What is discounted cash flow?
Discounted cash flow (DCF) is a valuation method that estimates an investment's worth by calculating its expected future cash flows in today's money. It helps you determine whether an investment will be profitable by accounting for the time value of money.
Why DCF matters for your business:
- Compare projects to choose the most profitable option
- Decide on major purchases or expansions
- Predict long-term returns more accurately
- Check if future cash flows justify current investment costs
Money today is usually worth more than the same amount in the future because you can earn more with it.
Why is discounted cash flow important?
DCF analysis helps small businesses make better financial decisions by providing an objective way to compare investment opportunities and assess project viability.
- Value investments accurately
- Prioritise projects using consistent criteria
- Reduce risk by spotting investments that may not deliver expected returns
- Plan your strategy using data
- Value investments accurately
- Prioritise projects using consistent criteria
- Spot investments that may not deliver expected returns
- Plan your business growth using data
- Use for projects with predictable cash flows
- Apply to investments with clear timelines
- Estimate future revenues when you have reasonable data
- Projects with predictable cash flows
- Investments with clear timelines
- Situations where you can estimate future revenues reasonably
- Avoid for highly complex or unpredictable projects
- Be cautious with early-stage businesses with limited financial history
- Consider other methods in industries with rapidly changing market conditions
- Highly complex or unpredictable projects
- Early-stage businesses with limited financial history
- Industries with rapidly changing market conditions
How to calculate discounted cash flow
DCF calculation turns future cash projections into present-day values to help you decide on investments. Follow these three steps:
Step 1: Forecast future cash flowsProject how much money the investment will generate each year, which can involve techniques like calculating a Historic dividend growth rate to inform future estimates. Cash flow includes all money coming in from the investment, not just profit.
Step 2: Choose your discount rateSelect a percentage that represents your cost of capital or the return you could get from alternative investments. This accounts for risk and opportunity cost.
Step 3: Calculate present valueApply the DCF formula to convert future cash flows into today's money value. You can use calculators, spreadsheets, or manual calculation.
Important:Cash flow is not the same as profit. Use the Xero cash flow calculator to get accurate numbers for your DCF analysis.
Discounted cash flow formula
The DCF formula calculates present value by discounting future cash flows:
DCF = CF₁/(1+r)¹ + CF₂/(1+r)² + ... + CFₙ/(1+r)ⁿ
Formula components:
- Use CF₁, CF₂, CFₙ for cash flow in years 1, 2, and so on
- Set r as your discount rate (required rate of return)
- Choose n as the number of years you are projecting
What each component means:
- Count all money generated by the investment as cash flow (CF)
- Use your cost of capital or alternative investment return as the discount rate (r)
- Set the number of years you are forecasting as time periods (n), usually three to 10 years
You can calculate DCF manually using this formula. Or use an online DCF calculator or an Excel DCF template for faster results.
The DCF formula helps you value a project, investment or business. Find more ways to manage your finances and cash flow in this guide.
Discounted cash flow example
This DCF example shows how to check if an £11 million project investment will generate enough returns.
Project details:
- Initial investment: £11 million
- Project duration: 5 years
- Discount rate (WACC): 6%
- Goal: Determine if projected cash flows justify the investment
Projected cash flows are:
- Year 1: £1 million
- Year 2: £1 million
- Year 3: £4 million
- Year 4: £4 million
- Year 5: £6 million
Using these future cash flows and your 6% discount rate, your yearly discounted cash flows are:
Year 1
- Projected Cash Flow: £1,000,000
- Discounted Cash Flow (rounded to nearest pound): £943,396
Year 2
- Projected Cash Flow: £1,000,000
- Discounted Cash Flow (rounded to nearest pound): £889,996
Year 3
- Projected Cash Flow: £4,000,000
- Discounted Cash Flow (rounded to nearest pound): £3,358,477
Year 4
- Projected Cash Flow: £4,000,000
- Discounted Cash Flow (rounded to nearest pound): £3,168,375
Year 5
- Projected Cash Flow: £6,000,000
- Discounted Cash Flow (rounded to nearest pound): £4,483,549
Compare the total discounted cash flows to your initial investment to see if the project is profitable.
Final calculation:
- Add up total discounted cash flows: £12,843,793
- Subtract the initial investment: £11,000,000
- Get the net present value (NPV): £1,843,793
What this means: The positive NPV of £1,843,793 indicates the project will generate £1.84 million more than your initial investment in today's money. This suggests the project is financially viable and worth pursuing.
If the net present value (NPV) is positive, the investment is likely to be profitable. If it is negative, look at other options.
How to use discounted cash flow analysis for small businesses
DCF analysis helps small businesses evaluate major investment opportunities by comparing projected returns across different options.
- Launch new products and check if development costs will pay off
- Expand into new markets and compare potential revenue
- Buy equipment and see if it will pay for itself
- Buy another business and check if it will add long-term value
- Check if new products will cover development costs
- Compare revenue from different markets
- See if equipment will pay for itself
- Work out if buying another company will add long-term value
DCF analysis helps you see which projects give you the best return for your money.
Using discounted cash flow to make smarter investment decisions
To make good investment choices, you need to know which options give you the best return. DCF analysis gives you clear numbers to help you decide.
Why DCF matters for growing businesses:
- Use your capital on investments with the best returns
- Choose growth opportunities that match your goals
- Avoid investments that may not deliver enough returns
- Make decisions based on data, not guesswork
Xero accounting software gives you the financial data and cash flow tracking you need for accurate DCF calculations. You can use these tools to gather reliable figures and work with your accountant or bookkeeper to make informed investment decisions.
Make informed financial decisions with Xero
Understanding discounted cash flow helps you make better financial decisions. With clear, real-time insights into your finances, you can forecast future cash flows and check new opportunities. Use Xero accounting software to get the financial data you need to analyse investments, plan for growth, and run your business with confidence.
FAQs on discounted cash flow
Here are answers to some common questions about discounted cash flow.
Here are the answers to some common questions about discounted cash flow.
What is discounted cash flow in simple terms?
Discounted cash flow (DCF) shows you what an investment's future earnings are worth in today's money. It helps you see if a future return is worth your investment now.
Is DCF the same as NPV?
No, but they are closely related. Discounted cash flow (DCF) is the total value of all future cash flows in today's money. Net present value (NPV) is the DCF minus the initial cost of the investment. A positive NPV means the investment is likely profitable.
What does a DCF analysis tell you about an investment?
A DCF analysis gives you an estimate of what an investment is worth based on the money it should generate. It helps you decide if an investment, project or business is priced fairly and will give you a good return.
When should small businesses use DCF analysis?
Small businesses can use DCF analysis for big financial decisions. This includes checking a new project, buying equipment, expanding into a new market, or working out the value of the business for sale or investment.
What are the main limitations of DCF analysis?
DCF works best for projects with predictable cash flows. It relies on your predictions, so accurate forecasts and choosing the right discount rate are important.
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Disclaimer
Xero does not provide accounting, tax, business or legal advice. This guide has been provided for information purposes only. You should consult your own professional advisors for advice directly relating to your business or before taking action in relation to any of the content provided.
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Access Xero features for 30 days, then decide which plan best suits your business.