Understanding the value of an investment is an essential way to make a more informed decision. However, it can be complex to determine the value, especially when considering future earnings and the time value of money. This is where discounted cash flow (DCF) analysis can be used. It offers a straightforward way to figure out the value of an investment based on the money it will make in the future.
In this blog we’ll cover:
- What is discounted cash flow (DCF)
- Discounted cash flow formula
- Why discounted cash flow matters
- How to use discounted cash flow for your business
- Looking to boost your cash flow?
What is discounted cash flow (DCF)
Discounted cash flow is a valuation method used to estimate the value of an investment based on its expected future cash flows. Unlike other valuation techniques that might only consider current earnings or asset values, discounted cash flow accounts for the time value of money. It recognises that £1 today is worth more than £1 received in the future, due to factors like inflation.
Discounted cash flow formula
The discounted cash flow formula calculates the current value of future cash flows.Essentially, it’s a way of looking at how much money you'll receive in the future and working out what that's worth in today's terms.
Here's a breakdown of how the discounted cash flow formula works:
You take each expected cash flow (like how much money you'll make each year or month) and divide it by (1+r) raised to the power of the number of years or months in the future it is expected. Then, you add up all these values.
The formula for discounted cash flow is:
DCF=(1+r)1CF1+(1+r)2CF2+(1+r)nCFn+(1+r)nTV
- DCF = the discounted cash flow, which is what we're trying to find.
- CF = the cash flow for each period (like how much money you'll make each year or month).
- r = is the discount rate, which is how much we reduce future cash flows to reflect the time value of money.
- n = is the number of periods (years or months) into the future each cash flow is expected.
- TV = is the terminal value, which is the value of the investment at the end of the forecast period.
By using this formula, you can figure out how much an investment is worth today, based on the money you expect it to make in the future.
Why discounted cash flow matters
Discounted cash flow can be a powerful tool to make informed decisions. It gives you a complete view of your investment's value by looking at all the cash it's expected to generate.
This helps you understand and manage the risks involved by factoring in the discount rate.
Whether you're thinking about buying another business, investing in new equipment, or starting a new project, discounted cash flow gives you all the numbers to make informed decisions. By ensuring your investments align with your long-term goals, you’ll be helping your business to grow in the right direction.
How to use discounted cash flow for your business
Here are some key steps for using discounted cash flow:
Make sure that your cash flow projections are accurate. Base the projections on realistic assumptions that are grounded in market research and historical performance data. You can use a cash flow forecast template to work out your cash flow projections.
You could assess and incorporate risk factors specific to your business and its industry into your analysis. This could include factors such as market competition, regulatory changes, technological advancements, and economic conditions that can impact future cash flows and the discount rate.
It’s important to continuously monitor and adjust the discounted cash flow as circ*mstances evolve. This will ensure that the discounted cash flow remains a relevant and reliable tool.
Looking to boost your cash flow?
Having access to short term finance or a line of credit gives you the flexibility to boost cash flow when you need it.
At Capitalise, we work with 100+ business lenders to help find the right option for your business. So if you’re looking to cover a cash flow shortfall, just search for funding and one of our dedicated funding specialists can help.
