What is Discounted Cash Flow?

Discounted Cash Flow (DCF) uses an estimated future cash flow amount and a Discount Rate to determine the Present Value (PV).

An investor or business executive might project an estimated future cash flow for a business based on recent growth rates, industry information, futurism, estimated inflation, etc. The most common future cash flow to use is free cash flow, which takes out capital expenditures.

Using a discount rate, which is a rate of growth weighted for all of the returns and inflation and so on which will affect the business between the present and the future date, the future value is discounted for all the intervening years, and the Present Value will be given.

The present value dollars are going to be less in quantity than the future value’s dollars, because, in what is known as the Time Value of Money, today’s dollars are worth more than tomorrow’s dollars, so it takes fewer of today’s dollars to equal tomorrow’s dollars.

The DCF originated from discounted dividend calculations, where investors sought to compute the present value of future dividends, but since not all stocks pay dividends, the DCF is used often to value the underlying shareholder’s equity. Discounting all the way back to the initial investment yields the Net Present Value.