What are discounted cash flow and the time value of money?

Discounted cash flow DCF is an application of the time-value-of-moneyconcept—the idea that money to be received or
paid at some time in the future has less value, today, than an equal amount actually received or paid today.
The DCF calculation finds the value appropriate today—the present value—for the future cash flow. The term
"discounting" applies because the DCF present value is always lower than the cash flow future value.
In modern finance, time-value-of-money concepts play a central role in decision support and planning. When investment
projections or business case results extend more than a year into the future, professionals trained in finance usually want
to see cash flows presented in two forms, in discounted terms and in non discounted terms. Financial specialists, that is,
want to see the time-value-of-money impact on long-term projections.
In discounted cash flow analysis, two value terms are central:
Present value (PV) is what the future cash flow is worth today.
Futue value (FV) is the value, in non discounted currency units that actually flows in or out at the future time.
A $100 cash inflow that will arrive two years from now could, for example, have a present value today of about $95, while
its future value is by definition $100.
For each cash flow event, the present value is discounted below the future value, except for cash flow events occuring
today, in which case PV=FV).
The longer the time period before an actual cash flow event occurs, the more the present value of future money is
discounted below its future value.
The total discounted value (present value) for a series of cash flow events across a time period extending into the future
is the net present value (NPV) of a cash flow stream.
DCF can be an important factor when evaluating or comparing investments, proposed actions, or purchases. Other things
being equal, the action or investment with the larger PV or larger NPV is the better decision.
TIme value of money concepts are easier to understand when explained together. Sections below further explain and
illustrate related terms and concepts including:
Discounted cash flow (DCF)
Cash flow stream
Present value (PV)
Future Value (FV)
Discount rate
Net present value (NPV)
Interest
Compound interest growth
Period-end discounting
Year-end discounting
Mid-period discounting
Mid-year discounting
Contents
Is "time value" of money tangible real value? Why is the time value of money concept important in
finance?
When first presented with the definition of discounted cash flow, many people understandably react with comments like
these: "It sounds like fiction" or "The time value of money cannot refer to real value, because DCF does not measure real
cash flow" or "It's an interesting calculation, but there's no tangible value involved."
However, business professionals recognize that the results of discounting calculations do represent real tangible value,
readily seen if the time value of money concept is stated like this:
Having the use of money for a specific period of time has value that is tangible, measurable, and real.
Discounted cash flow (DCF) is one application of this concept, while interest paid for a loan is another. With DCF, the
present value PV of future funds is discounted below future value FV of the funds for at least three reasons:
Opportunity. Money you have now could (in principle) be invested now, and gain return or interest between now and the
future time. Money you will not have until a future time cannot be used now.
Risk. Money you have now is not at risk. Money expected in the future is less certain. A well known proverb states this
principle more colorfully: "A bird in hand is worth two in the bush."
Inflation: A sum you have today will very likely buy more than an equal sum you will not have until years in future.
Inflation over time reduces the buying power of money.
Defining present value, future value, and net present value.
What future money is worth today is called its present value (PV) and what it will be worth in the future when it finally
arrives is called not surprisingly its future value (FV).
The right to receive a $100 payment one year from now (the future value) might be worth to us today $95 (its present
value).
Present value in other words, is discounted below future value.
Present values for a cash flow stream
When the analysis concerns a series of cash inflows or outflows coming at different future times, the series is called
a cash flow stream. Each future cash flow has its own value today (its own present value). The sum of these present
values is the net present value for the cash flow stream.
Consider an investment today of $100, that brings net gains of $100 each year for 6 years. The future values and present
values of these cash flow events might look like this:

All three sets of bars represent the same investment cash flow stream.
Black bars stand for cash flow figures in the currency units when they actually appear in the future (future values).
Lighter bars are values of the same cash flows now, in present value terms.
The net values in the legend show that after five years, the net cash flow expected is $500, but the Net present
value (NPV) today is discounted to something less.
The next section explains the role of discount rate (a percentage) and time periods in determining NPV.
Interest rates and time periods in discounting
The size of the discounting effect depends on two things: the amount of time between now and each future payment
(the number of discounting periods) and an interest rate called the discount rate. The example shows that:
As the number of discounting periods between now and the cash arrival increases, the present value decreases.
As the discount rate (interest rate) in the present value calculations increases, the present value decreases.
Whether you will or will not calculate present values yourself, your ability to use and interpret NPV / DCF figures will
benefit from a simple understanding of the way that interest rates and discounting periods work together in discounting.
If you wish to skip the next section on mathematics, however, click here to go directly to "Choosing a Discount Rate."
What are the mathematics involved in calculating DCF and NPV?
Many if not most business people outside of finance, are unfamiliar with time value of money terms and calculations. The
subject becomes approachable, however, if the explanation begins by noting that DCF mathematics are very closely
related to a subject that is familiar to most people: calculations for interest growth and compounding.
Remember briefly how interest calculations work. The FV formula looks into the future and might ask, for instance: What
is the future value (FV) in one year, of $100 invested today (the PV), at an annual interest rate of 5%?
FV1 = $100 ( 1 + 0.05)1 = $105
When the FV is more than one period into the future, as most people know, interest compounding takes place. Interest
earned in earlier periods begins to earn interest on itself, in addition to interest on the original PV. Compound interest
growth is delivered by the exponent in the FV formula, showing the number of periods. What is the future value in five
years of $100 invested today at an annual interest rate of 5%?.
FV5 = $100 ( 1 + 0.05)5 = $128

The same formula can be rearranged to deliver a present value given a future value and interest rate for input, as shown
at left.
Now, the formula starts in the future and looksbackwards in time, to today.
The formula now asks: What is the value today of a $100 payment arriving in one year, using a discount rate of 5%?
PV1 = ($100) / (1.0 + 0.05)1
= $100 / (1.05)
= $95
You should be able to see why PV will decrease if we either (a) increase the interest rate, or (b) increase the number of
periods before the FV arrives. What is the present value of $100 we will receive in 5 years, using a 5% discount rate?
PV5 = $100 / (1.0 +0.05)5
= $100 / (1.276)
= $75.13
When the FV is more than one period into the future, as most people know, interest compounding takes place. Interest
earned in earlier periods begins to earn interest on itself, in addition to interest on the original PV. Compound interest
growth is delivered by the exponent in the FV formula, showing the number of periods. What is the future value in five
years of $100 invested today at an annual interest rate of 5%?.
FV5 = $100 ( 1 + 0.05)5
= $128
When discounting is applied to a series of cash flow events, a cash flow stream, as illustrated in the graph example above,
net present value for the stream is the sum of PVs for each FV:

The formula now asks: What is the value today of a $100 payment arriving in one year, using a discount rate of 5%?
PV1 = ($100) / (1.0 + 0.05)1
= $100 / (1.05)
= $95
You should be able to see why PV will decrease if we either (a) increase the interest rate, or (b) increase the number of
periods before the FV arrives. What is the present value of $100 we will receive in 5 years, using a 5% discount rate?
PV5 = $100 / (1.0 +0.05)5
= $100 / (1.276)
= $75.13
Should you use mid-period (or mid-year) discounting? What difference does it make?
Finally, note two commonly used variations on the examples shown thus far. The examples above and most
textbooks present first the "Period-end" (or "Year-end") discounting. Period-end discounting is the more frequently used
DCF approach. The approach, moreover, usually turns up as the default approach for spreadsheet and calculator DCF
functions.
Period-end discounting
With the period-end approach, all discounting for a period is applied as though all cash flow occurs on the last day of the
period. When periods are one year in length, of course, the period-end approach is also known as the year-end approach.
With year-end discounting, all of the period's cash flow is assumed to occur on day 365 of the year.
Mid-period discounting
Some financial analysts, however, prefer to assume that cash flows are distributed more or less evenly throughout the
period. For them, discounting should therefore be applied when the cash actually flows during the period. For calculating
present values this way, it is mathematically equivalent to calculate as though all cash flow occurs at mid-period. For this
reason, this approach is called mid-period discounting. And, of course, the name mid-year discounting applies when
periods are one year in length.
What are the differences between the two approaches?
Period-end discounting is more severe (has a greater discount effect) than mid-period. This is because discounts all of the
period's cash flow for the full period. You can seehow this works mathematically from the formulas in the next section.
Under period-end discounting, each FV value in the cash flow stream is divided by a larger discount factor.

Some analysts prefer to describe this difference by saying the period-end approach is more conservative.
Those preferring the other approach say that discounting mid-period is moreaccurate.

Remember that the discount rate recognizes the values of opportunity, risk, and inflation—values that change
continuously as time passes. Miid-period discounting comes closer, they say, to applying the discounting effect precisely
when cash actually flows.
Formulas for mid-period discounting
The formulas below show NPV calculations for mid-year discounting (upper formula) and for discounting with periods
other than one year (lower formula).
The panel at left identifies symbols used for quarterly and mid-year discounting calculations.
In any case, the business analyst will want to find out which of the above discount methods is preferred by the
organization's financial specialists, and why, and follow their practice (unless there is justification for doing otherwise).
Working examples of these formulas, along with guidance for spreadsheet implementation and good-practice usage are
available in the spreadsheet-based toolFinancial Metrics Pro.
How is the discount (interest) rate chosen for discounted cash flow analysis?
The analyst will also want to find out from the organization's financial specialists which discount rate the organization
uses for discounted cash flow analysis. Financial officers who have been with an organization for some time, usually
develop good reasons for choosing one rate or another as the most appropriate rate for the organization.
In private industry, many companies use their own cost of capital (or weighted average cost of capital) as the preferred
discount rate.
Government organizations typically prescribe a discount rate for use in the organization's planning and decision support
calculations. In the United States, for instance, the Office of Management and Budget (OMB) publishes a quarterly
circular with prescribed discount rates for Federal Government use.
Financial officers may use a higher discount rate for investments or decisions viewed as risky, and a lower discount
rate when expected returns from a proposed action are seen as less risky. The higher rate is viewed as a hedge against
risk, because it puts relatively more emphasis (weight) on near-term returns compared to distant future returns.

What is a 'Discounted Cash Flow (DCF)'

A discounted cash flow (DCF) is a valuation method used to estimate the
attractiveness of an investment opportunity. DCF analysis uses future
free cash flow projections and discounts them to arrive at a present
value estimate, which is used to evaluate the potential for investment. If
the value arrived at through DCF analysis is higher than the current cost
of the investment, the opportunity may be a good one.

Calculated as:

DCF is also known as the Discounted Cash Flows Model.

BREAKING DOWN 'Discounted Cash Flow (DCF)'

There are several variations when it comes to assigning values to cash
flows and the discount rate in a DCF analysis. But while the calculations
involved are complex, the purpose of DCF analysis is simply to estimate
the money an investor would receive from an investment, adjusted for
the time value of money.

The time value of money is the assumption that a dollar today is worth
more than a dollar tomorrow. For example, assuming 5% annual interest,
$1.00 in a savings account will be worth $1.05 in a year. Due to the
symmetric property (if a=b, then b=a), we must consider $1.05 a year from
now to be worth $1.00 today. When it comes to assessing the future value
of investments, it is common to use the weighted average cost of capital
(WACC) as the discount rate.

For a hypothetical Company X, we would apply DCF analysis by first

estimating the firm's future cash flow growth. We would start by
determining the company's trailing twelve month (ttm) free cash flow
(FCF), equal to that period's operating cash flow minus capital
expenditures. Say that Company X's ttm FCF is $50 m. We would compare
this figure to previous years' cash flows in order to estimate a rate of
growth. It is also important to consider the source of this growth. Are
sales increasing? Are costs declining? These factors will inform
assessments of the growth rate's sustainability.

Say that you estimate that Company X's cash flow will grow by 10% in the
first two years, then 5% in the following three. After a few years, you may
apply a long-term cash flow growth rate, representing an assumption of
annual growth from that point on. This value should probably not exceed
the long-term growth prospects of the overall economy by too much; we
will say that Company X's is 3%. You will then calculate a WACC; say it
comes out to 8%. The terminal value, or long-term valuation the
company's growth approaches, is calculated using the Gordon Growth
Model:

Terminal value = projected cash flow for final year (1 + long-term growth
rate) / (discount rate - long-term growth rate)

Now you can estimate the cash flow for each period, including the the
terminal value:

Year 1 = 50 * 1.10 55
Year 2 = 55 * 1.10 60.5
Year 3 = 60.5 * 1.05 63.53
Year 4 = 63.53 * 1.05 66.70
Year 5 = 66.70 * 1.05 70.04
Terminal value = 70.04 (1.03) / (0.08 - 0.03) 1,442.75

Finally, to calculate Company X's discounted cash flow, you add each of
these projected cash flows, adjusting them for present value using the
WACC:

DCFCompany X = (55 / 1.081) + (60.5 / 1.082) + (63.53 / 1.083) + (66.70 / 1.084) +

(70.04 / 1.085) + (1,442.75 / 1.085) = 1231.83

$1.23 b is our estimate of Company X's present enterprise value. If the

company has net debt, this needs to be subtracted, as equity holders'
claims to a company's assets are subordinate to bondholders'. The result
is an estimate of the company's fair equity value. If we divide that by the
number of shares outstanding—say 10 m—we have a fair equity value per
share of $123.18, which we can compare with the market price of the
stock. If our estimate is higher than the current stock price, we might
consider Company X a good investment.

Discounted cash flow models are powerful, but they are only as good as
their imports. As the axiom goes, "garbage in, garbage out". Small
changes in inputs can result in large changes in the estimated value of a
company, and every assumption has the potential to erode the estimate's
accuracy.

The difference is the time value of money, one of

the key concepts of Finance.
Let's say that I contract to pay you $100 per year for ten years, with the first payment due
today, the next one due a year from today, and so forth. The question that arises is "how
much is that whole contract worth today?"

Using un-discounted cash flow analysis, the math is very simple: 10 payments x $100
means that flow of cash over ten years is worth $1,000 right?

But let me ask you a question: would you be willing to pay me $1,000 in cash today to
purchase that contract? Somehow, I doubt it. Why? Because what would be your motivation
to give up the cash in your hand now, in exchange for getting the last of it back a decade
from now?!

So, if the actual dollars are the same, but you value my promised $1,000-over-a-
decadeless than you value the $1,000 already-in-your-hand, our goal is to figure out what
that contract is really worth. So how do we do that?

We start by calculating a discount for the value of each individual payment (that is, we
figure out how much less than $100 this year's payment is worth to you, then we do it again
for next year's, and so forth) and then we add up all those numbers. Those payments
happening every year are considered a flow of cash. So our analysis of that flow—taking
into account the discounts in value of each of the payments—is called thediscounted cash
flow analysis.

Now that we think about, how can you figure out exactly how much less $100 next year is
worth to you than $100 right now? The best way is to think about what you would do with
that money if you had the use of it for a year. In the financial context we're talking about, we
can use as a proxy for this some other investment available to you that will generate a
certain return over that period. Let's say that you know that the best return you could get on
your $100 today would be to put it in the stock market, where you are convinced that you
could get a 10% annual return. The corollary of this, therefore, is that by not having that
$100 this year, you would not get that 10% return. Therefore, we have established that
your discount rate is 10%.

So now let's do the math, seeing what each of those annual $100 payments is really worth to
you, knowing as you do that if you had it now instead of in the future, you could make 10%
each year on it. We call this the net present value of that particular payment, and can
think about it this way: The first payment comes in today, and you can turn around and put
it right to work, so there's no discount. That means the value of that first payment to you is
the full $100.

The second payment, however, is a year away, and by that point you know that you could
have earned 10% on it, so to calculate its present value, we use the formula:

Substituting our numbers, we get $100 (cash to be received) divided by [1 + 10%], which
reduces to 100/1.10, which equals $90.91.
For the third year it gets slightly trickier, because now we have to calculate the
discounttwice, because it's two years away. We do that by squaring the discount, using the
following formula:

Plugging in our numbers again, this time we get 100/[1.1]^2, = 100/1.21 = $82.64. Doing
the same thing for each year in the series, the different numbers look like this (remember,
we're getting paid at the beginning of each year):

As you can see, this means that while the un-discounted cash flow analysis would have you
thinking that you'd be getting $1,000 over the ten years (which you would, technically),
adiscounted cash flow analysis using your own discount rate shows that the value of
that whole stream of cash flows—right here, right now—is in reality worth to you
only$675.90.

The full mathematical calculations to figure all this out are built into spreadsheets
likeMicrosoft Excel, and financial calculators like the HP12C. There's also a very nice
interactive online NPV calculator (from which the above table was generated) atCalculator
Soup.

You can see the detailed formula (with a good explanation) in the Wikipedia article
onDiscounted cash flow:

Written Oct 6, 2014 ∙ View Upvotes

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Airen Abramov
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Discounted cash flow is a valuation method used to estimate the attractiveness of an
investment opportunity. Discounted cash flow (DCF) analysis uses future free cash
flowprojections and discounts them to arrive at a present value estimate, which is used to
evaluate the potential for investment. If the value arrived at through DCF analysis is higher
than the current cost of the investment, the opportunity may be a good one.

Calculated as: