Investments are the discounted present value of all future free cash flow.
Discounted cash flow (DCF) is a method of investment valuation in which future cash flows are discounted back to a present value using the time-value of money.
Present value (PV) is a financial calculation that measures the worth of a future amount of money or an investment’s future cash flow in today’s dollars adjusted for interest and inflation. In other words, it compares the buying power of one future dollar to purchasing power of one today.
PV is an indication of whether the money an investor receives today can earn a return in the future. Investors calculate the present value of a firm’s expected cash flows to decide if the stock is worth investing in today.
An investment’s worth is equal to the present value of all projected discounted future cash flows.
Discounted cash flow is a way of evaluating a potential investment by estimating future income streams and determining the present worth of all of those cash flows in order to compare the cost of the investment to its return.
When an investor is trying to determine how to spend capital, it is important to determine whether or not investments will result in a positive return. The DCF method allows an investor to determine the value of the future projected cash flow in today’s dollars. An investor can subtract the amount spent on the investment from the present value of future cash flows to calculate the net present value of the investment.
In other words, they can calculate how much money the investment will make in today’s dollars and compare it with the cost of the investment. NPV and Internal Rate of Return are the methods used in Discounted Cash Flow.
The Net Present Value (NPV) represents the present value of cash flow. The NPV can also be called as the difference between the present values of cash inflow and cash outflow. To calculate the net present value of an investment using the discounted cash flows method:
Example – an investor is considering investing in property that would cost his LLC $1,000,000 and he hold it for 5 years. What is the net present value of this investment using the discounted cash flows method?
The investor determined the discount rate to be 10%. With this information, he calculated the following future discounted cash flows:
- Year 1 = $130,000
- Year 2 = $150,000
- Year 3 = $200,000
- Year 4 = $210,000
- Year 5 = $200,000
The total projected cash flows is $890,000.
The net present value of this investment is $890,000-$1,000,000 which is equal to -$110,000.
In this example, an investor should not make this investment because the original cost (cost basis) is greater than the value of the future discounted cash flow creating a negative return over the time period.
As in this example, the DCF is compared with the initial investment. If the DCF is greater than the original cost, the investment is profitable. The higher the DCF, the greater return the investment generates. If the DCF is lower than the present cost, investors should rather hold the cash.
An investor’s expected cash flows are at a discount rate that is actually the expected return. The discount rate is inversely correlated to the future cash flows. The higher the discount rate, the lower the present value of the expected cash flows.
The NPV represents the present value of cash flow and is generally used for comparing both the internal and the external investments of a company. DCF is a method to calculate the value of an investment based on the present value of its future cash flow.
References:
- https://www.myaccountingcourse.com/accounting-dictionary/discounted-cash-flow
- https://corporatefinanceinstitute.com/resources/knowledge/valuation/discounted-cash-flow-dcf/
- https://www.myaccountingcourse.com/accounting-dictionary/present-value