Discounted cash flow (DCF) uses the time value of money to assess and compare investments.
There are two crucial parts of the valuation – the discount and the cash flow. Both must be estimated by the investor.
The cash flow is how much money the investment will return annually. It might, for example, be the interest paid by a bond or the earnings per share from a stock.
The discount is the percentage by which the investor believes the annual return must be reduced. For example, the interest rate from a bond could be the cash flow, and the discount rate could be the expected rate of inflation.
The discount rate need not be the rate of inflation. For example, an investor might consider investing in company shares. He might use the interest rate on government bonds as the discount rate. He would then be said to have taken the risk free rate of return as his discount rate.
Alternatively, he might say he’s not interested in investing in anything that won’t return at least 10 percent a year and set 10 percent as the discount rate.
Example
An investor usually sets a discount rate of 13%. She believes this is sufficient to cover inflation and most risks. For several years, she has been successful in choosing investments that are successful at this discount rate. (If she believes an investment carries unusually high risks, she sets a higher discount rate.)
She is offered the opportunity to buy bonds in a blue chip company. The bonds promise to pay investors a lump sum that’s double their original investment in six years’ time.
To assess whether to invest $100,000 in order to receive $200,000 in six years’ time she calculates the present value of the future cash flow using her chosen discount rate of 0.13.
PV = FV / (1 + d)n
where:
PV = Present Value
FV = Future Value
d = discount rate
n = number of years
PV = $200,000/(1 + 0.13)6
hence:
PV = $96,063
The present value of the bond is worth less to the investor than her money currently has, therefore she declines the opportunity to buy these bonds.