Discounted cash ow

tuitive decision-making, but are not generally used in industry.

The discount rate used is generally the appropriate
weighted average cost of capital (WACC), that reects
the risk of the cashows. The discount rate reects two
things:
1. Time value of money (risk-free rate) according to
the theory of time preference, investors would rather
have cash immediately than having to wait and must
therefore be compensated by paying for the delay
2. Risk premium reects the extra return investors
demand because they want to be compensated for
the risk that the cash ow might not materialize after
all

Spreadsheet uses Free cash ows to estimate stocks Fair Value

and measure the sensibility of WACC and Perpetual growth

2 History

In nance, discounted cash ow (DCF) analysis is a

method of valuing a project, company, or asset using the
concepts of the time value of money. All future cash
ows are estimated and discounted by using cost of capital to give their present values (PVs). The sum of all
future cash ows, both incoming and outgoing, is the net
present value (NPV), which is taken as the value or price
of the cash ows in question.[1]

Discounted cash ow calculations have been used in some

form since money was rst lent at interest in ancient times.
Studies of ancient Egyptian and Babylonian mathematics
suggest that they used techniques similar to discounting
of the future cash ows. This method of asset valuation
dierentiated between the accounting book value, which
is based on the amount paid for the asset.[2] Following the
stock market crash of 1929, discounted cash ow analysis gained popularity as a valuation method for stocks.
Irving Fisher in his 1930 book The Theory of Interest and
John Burr Williams's 1938 text The Theory of Investment
Value rst formally expressed the DCF method in modern economic terms.[3]

Using DCF analysis to compute the NPV takes as input cash ows and a discount rate and gives as output a
present value; the opposite processtakes cash ows and
a price (present value) as inputs, and provides as output
the discount ratethis is used in bond markets to obtain
the yield.
Discounted cash ow analysis is widely used in investment nance, real estate development, corporate nancial
management and patent valuation.

3 Mathematics
3.1 Discounted cash ows

Discount rate

The discounted cash ow formula is derived from the

future value formula for calculating the time value of
money and compounding returns.

Main article: Discounting

The most widely used method of discounting is exponential discounting, which values future cash ows as how
CF2
CFn
CF1
much money would have to be invested currently, at a
+
+ +
DCF =
given rate of return, to yield the cash ow in future.
(1 + r)1
(1 + r)2
(1 + r)n
Other methods of discounting, such as hyperbolic discounting, are studied in academia and said to reect in- F V = DCF (1 + r)n
1

Thus the discounted present value (for one cash ow in

one future period) is expressed as:

DP V =

FV
(1 + r)n

where

EXAMPLE DCF

4 Example DCF
To show how discounted cash ow analysis is performed,
consider the following simplied example.
John Doe buys a house for $100,000. Three years
later, he expects to be able to sell this house for
$150,000.

DPV is the discounted present value of the future Simple subtraction suggests that the value of his prot
cash ow (FV), or FV adjusted for the delay in re- on such a transaction would be $150,000 $100,000
ceipt;
= $50,000, or 50%. If that $50,000 is amortized over
the three years, his implied annual return (known as the
FV is the nominal value of a cash ow amount in a
internal rate of return) would be about 14.5%. Looking
future period;
at those gures, he might be justied in thinking that the
r is the interest rate or discount rate, which reects purchase looked like a good idea.
the cost of tying up capital and may also allow for the 1.1453 x 100000 = 150000 approximately.
risk that the payment may not be received in full;[4]
However, since three years have passed between the pur n is the time in years before the future cash ow oc- chase and the sale, any cash ow from the sale must be
discounted accordingly. At the time John Doe buys the
curs.
house, the 3-year US Treasury Note rate is 5% per anWhere multiple cash ows in multiple time periods are num. Treasury Notes are generally considered to be inherently less risky than real estate, since the value of the
discounted, it is necessary to sum them as follows:
Note is guaranteed by the US Government and there is a
liquid market for the purchase and sale of T-Notes. If he
hadn't put his money into buying the house, he could have
N

F Vt
invested it in the relatively safe T-Notes instead. This 5%
DP V =
t
(1
+
r)
per annum can therefore be regarded as the risk-free int=0
terest rate for the relevant period (3 years).
for each future cash ow (FV) at any time period (t) in
Using the DPV formula above (FV=$150,000, i=0.05,
years from the present time, summed over all time pen=3), that means that the value of $150,000 received
riods. The sum can then be used as a net present value
in three years actually has a present value of $129,576
gure. If the amount to be paid at time 0 (now) for all
(rounded o). In other words we would need to invest
the future cash ows is known, then that amount can be
$129,576 in a T-Bond now to get $150,000 in 3 years
substituted for DPV and the equation can be solved for r,
almost risk free. This is a quantitative way of showing
that is the internal rate of return.
that money in the future is not as valuable as money in
All the above assumes that the interest rate remains con- the present ($150,000 in 3 years isn't worth the same as
stant throughout the whole period.
$150,000 now; it is worth $129,576 now).
If the cash ow stream is assumed to continue indenitely, the nite forecast is usually combined with the assumption of constant cash ow growth beyond the discrete projection period. The total value of such cash ow
stream is the sum of the nite discounted cash ow forecast and the Terminal value (nance).

Subtracting the purchase price of the house ($100,000)

from the present value results in the net present value of
the whole transaction, which would be $29,576 or a little
more than 29% of the purchase price.

3.2

But what about risk?

Continuous cash ows

Another way of looking at the deal as the excess return

achieved (over the risk-free rate) is (114.5 - 105)/(100 +
5) or approximately 9.0% (still very respectable).

We assume that the $150,000 is Johns best estimate of

For continuous cash ows, the summation in the above
the sale price that he will be able to achieve in 3 years
formula is replaced by an integration:
time (after deducting all expenses, of course). There is
of course a lot of uncertainty about house prices, and the
T
outcome may end up higher or lower than this estimate.
DP V =
F V (t) et dt ,
(The house John is buying is in a good neighborhood,
0

but market values have been rising quite a lot lately and
where F V (t) is now the rate of cash ow, and = the real estate market analysts in the media are talking
log(1 + r) .
about a slow-down and higher interest rates. There is

3
a probability that John might not be able to get the full
$150,000 he is expecting in three years due to a slowing
of price appreciation, or that loss of liquidity in the real
estate market might make it very hard for him to sell at
all.)

lined below. The details are likely to vary depending

on the capital structure of the company. However the
assumptions used in the appraisal (especially the equity
discount rate and the projection of the cash ows to be
achieved) are likely to be at least as important as the preUnder normal circumstances, people entering into such cise model used.
transactions are risk-averse, that is to say that they are Both the income stream selected and the associated cost
prepared to accept a lower expected return for the sake of of capital model determine the valuation result obtained
avoiding risk. See Capital asset pricing model for a fur- with each method. This is one reason these valuation
ther discussion of this. For the sake of the example (and methods are formally referred to as the Discounted Futhis is a gross simplication), lets assume that he values ture Economic Income methods.
this particular risk at 5% per annum (we could perform
a more precise probabilistic analysis of the risk, but that
Equity-Approach
is beyond the scope of this article). Therefore, allowing
Flows to equity approach (FTE)
for this risk, his expected return is now 9.0% per annum
(the arithmetic is the same as above).
Discount the cash ows available to the holders of equity
And the excess return over the risk-free rate is now (109
capital, after allowing for cost of servicing debt capital
- 105)/(100 + 5) which comes to approximately 3.8% per
Advantages: Makes explicit allowance for the cost of debt
annum.
capital
That return rate may seem low, but it is still positive after
all of our discounting, suggesting that the investment de- Disadvantages: Requires judgement on choice of discision is probably a good one: it produces enough prot count rate
to compensate for tying up capital and incurring risk with
a little extra left over. When investors and managers per Entity-Approach:
form DCF analysis, the important thing is that the net
Adjusted present value approach (APV)
present value of the decision after discounting all future
cash ows at least be positive (more than zero). If it is
negative, that means that the investment decision would Discount the cash ows before allowing for the debt capactually lose money even if it appears to generate a nom- ital (but allowing for the tax relief obtained on the debt
inal prot. For instance, if the expected sale price of capital)
John Does house in the example above was not $150,000 Advantages: Simpler to apply if a specic project is bein three years, but $130,000 in three years or $150,000 ing valued which does not have earmarked debt capital
in ve years, then on the above assumptions buying the nance
house would actually cause John to lose money in presentvalue terms (about $3,000 in the rst case, and about Disadvantages: Requires judgement on choice of dis$8,000 in the second). Similarly, if the house was located count rate; no explicit allowance for cost of debt capital,
in an undesirable neighborhood and the Federal Reserve which may be much higher than a risk-free rate
Bank was about to raise interest rates by ve percentage

Weighted average cost of capital approach

points, then the risk factor would be a lot higher than 5%:
(WACC)
it might not be possible for him to predict a prot in discounted terms even if he thinks he could sell the house
for $200,000 in three years.
Derive a weighted cost of the capital obtained from the
In this example, only one future cash ow was consid- various sources and use that discount rate to discount the
ered. For a decision which generates multiple cash ows cash ows from the project
in multiple time periods, all the cash ows must be dis- Advantages: Overcomes the requirement for debt capital
counted and then summed into a single net present value. nance to be earmarked to particular projects

Methods of appraisal of a company or project

Disadvantages: Care must be exercised in the selection of

the appropriate income stream. The net cash ow to total
invested capital is the generally accepted choice.

Total cash ow approach (TCF)

This is necessarily a simple treatment of a complex sub- This distinction illustrates that the Discounted Cash Flow
ject: more detail is beyond the scope of this article.
method can be used to determine the value of various
For these valuation purposes, a number of dierent DCF business ownership interests. These can include equity
methods are distinguished today, some of which are out- or debt holders.

10 FURTHER READING

Alternatively, the method can be used to value the company based on the value of total invested capital. In
each case, the dierences lie in the choice of the income
stream and discount rate. For example, the net cash ow
to total invested capital and WACC are appropriate when
valuing a company based on the market value of all invested capital.[5]

5 February 2015.
[2] O.E.H. Neugebaner, The Exact Sciences in Antiquity
(Copenhagen :Ejnar Mukaguard, 1951) p.33 (1969).
O.E.H. Neugebaner, The Exact Sciences in Antiquity
(Copenhagen :Ejnar Mukaguard, 1951) p.33. US: Dover
Publications. p. 33. ISBN 0486223329.
[3] Fisher, Irving. The theory of interest. New York 43
(1930).

Shortcomings

Commercial banks have widely used discounted cash ow

as a method of valuing commercial real estate construction projects. This practice has two substantial shortcomings. 1) The discount rate assumption relies on the market for competing investments at the time of the analysis,
which would likely change, perhaps dramatically, over
time, and 2) straight line assumptions about income increasing over ten years are generally based upon historic
increases in market rent but never factors in the cyclical nature of many real estate markets. Most loans are
made during boom real estate markets and these markets
usually last fewer than ten years. Using DCF to analyze
commercial real estate during any but the early years of a
boom market will lead to overvaluation of the asset.
Discounted cash ow models are powerful, but they do
have shortcomings. DCF is merely a mechanical valuation tool, which makes it subject to the principle "garbage
in, garbage out". Small changes in inputs can result in
large changes in the value of a company. Instead of trying
to project the cash ows to innity, terminal value techniques are often used. A simple annuity (perpetuity??)
is used to estimate the terminal value past 10 years, for
example. This is done because it is harder to come to a realistic estimate of the cash ows as time goes on involves
calculating the period of time likely to recoup the initial
outlay.[6]
Another shortcoming is the fact that the Discounted Cash
Flow Valuation should only be used as a method of intrinsic valuation for companies with predictable, though
not necessarily stable, cash ows. The Discounted Cash
Flow valuation method is widely used in valuing mature
companies in stable industry sectors such as Utilities. At
the same time, this method is often applied to valuation
of high growth technology companies. In valuing young
companies without much cash ow track record, the Discounted Cash Flow method may be applied a number of
times to assess a number of possible future outcomes,
such as the best, worst and mostly likely case scenarios.

See also

References

[1] Wall Street Oasis (DCF)". Wall Street Oasis. Retrieved

[4] Discount rates and net present value. Centre for Social
Impact Bonds. Retrieved 28 February 2014.
[5] Pratt, Shannon; Robert F. Reilly; Robert P. Schweihs
(2000). Valuing a Business. McGraw-Hill Professional.
McGraw Hill. ISBN 0-07-135615-0.
[6] Discounted Cash Flow - DCF. investopedia.com. Retrieved 22 November 2010.

9 External links
Continuous compounding/cash ows
The Theory of Interest at the Library of Economics
and Liberty.
Monography about DCF (including some lectures on
DCF).
Foolish Use of DCF. Motley Fool.
Getting Started With Discounted Cash Flows. The
Street.
International Good Practice:
Guidance on
Project Appraisal Using Discounted Cash Flow,
International Federation of Accountants, June
2008, ISBN 978-1-934779-39-2
Equivalence between Discounted Cash Flow (DCF)
and Residual Income (RI) Working paper; Duke
University - Center for Health Policy, Law and Management
Download of business case spreadsheets
for discounted cash ow calculation http:
//www.thebusinesscase.info
(Downloads/For
Professionals and Students)

10 Further reading
International Association of CPAs, Attorneys, and
Management (IACAM) (Free DCF Valuation EBook Guidebook)
International Federation of Accountants (2007).
Project Appraisal Using Discounted Cash Flow.

5
Copeland, Thomas E.; Tim Koller; Jack Murrin
(2000). Valuation: Measuring and Managing the
Value of Companies. New York: John Wiley &
Sons. ISBN 0-471-36190-9.
Damodaran, Aswath (1996). Investment Valuation:
Tools and Techniques for Determining the Value of
Any Asset. New York: John Wiley & Sons. ISBN
0-471-13393-0.
Rosenbaum, Joshua; Joshua Pearl (2009). Investment Banking: Valuation, Leveraged Buyouts, and
Mergers & Acquisitions. Hoboken, NJ: John Wiley
& Sons. ISBN 0-470-44220-4.
James R. Hitchnera (2006). Financial Valuation:
Applications and Models. USA: Wiley Finance.
ISBN 0-471-76117-6.
Chander Sawhney (2012). Discounted Cash Flow
The Prominent Income Approach to Valuation. INDIA: .

11

11
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