What is discounted cash flow?
Discounted cash flow is a valuation method that estimates the value of an investment using its expected future cash flows. It can help you figure out if your investment will be worth it by predicting how much money you would receive on your investment, when taking into account the time value of money.
The time value of money assumes that your money today may be worth more than the money you receive in the future due to its investment potential. A DCF analysis can make it easier to judge which financial decisions are worth making in order to increase future returns.
DCF is not only useful to investors, helping them to make smart decisions when considering whether to acquire a company for example, but can also be useful to business owners and managers when deciding which new projects are worth pursuing. Through using DCF’s valuation model, you could make smarter capital budgeting or operating expenditure decisions, and significantly improve your financial planning.
Why is discounted cash flow important?
DCF can play a crucial role in financial decision-making for small businesses. By using this model, you could make more informed investment decisions and value your business more accurately. DCF is one of the best metrics for estimating the intrinsic value of an investment by taking into consideration multiple factors, including profit margins, future sales growth and the time value of money.
The benefits of using discounted cash flow analysis include more accurately evaluating the profitability and feasibility of your investments, projects and business strategies when compared to other valuation methods like comparable company analysis – giving you as a small business owner a better understanding of what to prioritise in terms of your spending. However, it’s worth bearing in mind that if a project is very complex or difficult to accurately predict future cash flows, a DCF analysis could prove inaccurate and another analysis model may be better suited to your needs.
How to calculate discounted cash flow
There are three steps to calculating DCF:
- Forecast the expected cash flows from the investment
- Select a discount rate (typically based on the cost of financing the investment or the opportunity cost presented by alternative investments)
- Discount the forecasted cash flows back to the present day, using a discounted cash flow calculator, spreadsheet or manual calculation (see below)
In order to make your calculation you’ll need to figure out your cash flow. Remember, cash flow is different from business profit, which would be revenue minus expenses. To provide accurate figures for each part of the DCF formula, use Xero’s cash flow calculator.
Discounted cash flow formula
You can calculate your DCF using this equation:
DCF = CF1 (1+r)1+ CF2(1+r)2 + ... + CFn (1+r)n
Here’s a breakdown of each part of the equation:
CF1 = The cash flow for year one CF2 = The cash flow for year two CFn = The cash flow for additional years (n represents number of years) r = The discount rate
Cash flow (CF) is any sort of earnings or dividends which can include revenues from sales of services or products, or cash from selling an asset. (See: How to calculate discounted cash flow.)
Number of periods (n) is the number of years in which the cash flows are expected to occur.
Discount rate (r) is a way of bringing future costs back to present value. Usually, the discount rate is the company’s cost of capital, or how much the company has to make to justify its operational costs. This cost is known as the weighted average cost of capital (WACC), and incorporates the company’s interest rate and loan payments, or dividend payments to shareholders.
The DCF formula can help you to more accurately value a project, investment or an entire business. Find more ways to manage finances and cash flow in our guide.
Discounted cash flow example
Let’s take a look at a simple discounted cash flow example.
Say your company has a big project to potentially take on and you want to figure out if it’ll be worth the investment. First, you take your company’s weighted average cost of capital (WACC), which for this example we’ll say is 6% – this will be your discount rate to use in the equation. The project will be five years long, and your company is putting in an initial investment of £11 million.
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:
- Projected Cash Flow: £1,000,000
- Discounted Cash Flow (rounded to nearest pound): £943,396
- Projected Cash Flow: £1,000,000
- Discounted Cash Flow (rounded to nearest pound): £889,996
- Projected Cash Flow: £4,000,000
- Discounted Cash Flow (rounded to nearest pound): £3,358,477
- Projected Cash Flow: £4,000,000
- Discounted Cash Flow (rounded to nearest pound): £3,168,375
- Projected Cash Flow: £6,000,000
- Discounted Cash Flow (rounded to nearest pound): £4,483,549
Next, we need to determine if the project is worth the investment. To do this, we’ll compare the initial investment to the sum of the discounted cash flows of the project.
- Initial Investment: £11,000,000
- Discount cash flow (DCF) sum: £12,843,793
- Net present value (NPV) for project: £1,843,793
To do this, subtract the initial investment cost from the sum of the discounted cash flows to get the net present value (NPV). In this case, the NPV is a positive number, meaning the project is likely to generate more money than the initial investment.
You can use this figure to determine whether it’s worth investing in the project.
How to use discounted cash flow analysis for small businesses
Discounted cash flow analysis can assist small businesses in making wise investment decisions when considering taking on a new product or service, expanding into a new market, or acquiring another company, ultimately helping to ensure future growth.
For instance, if as a small business owner you have an option of multiple projects to pursue but want to know if they might be worth the investment, you can use the DCF formula to predict whether they will all make money, and, if so, which one is projected to increase your business’s income the most. That way you can make strategic decisions with the best outcomes for your business in mind.
You can find more resources related to cash flow for small businesses at Xero’s cash flow resource hub here.
Using discounted cash flow to make smarter investment decisions
Discounted cash flow can be a handy tool to help decide where to invest your money. Small businesses in particular could find DCF useful as money can be tight and it can be difficult to pinpoint how best to grow and sustain your business. Using this analysis, you’ll be able to see which investment decisions are most likely to create profit for your company, help you to decide which direction your company should grow in and contribute to defining your longer term business goals.
Xero can help accountants and bookkeepers to calculate DCF by providing the financial tools to figure out your cash flow, as well as to keep track of all your accounting needs.
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.
Start using Xero for free
Access Xero features for 30 days, then decide which plan best suits your business.
- Safe and secure
- Cancel any time
- 24/7 online support