DCF Method

The DCF method calculates what someone is willing to pay today in order to receive the anticipated cash flow in future years. DCF means converting future earnings to today's money. The future cash flows must be discounted in order to express their present values in order to properly determine the value of a company or project under consideration as a whole.

The DCF for an investment is calculated by estimating the cash you will have to pay out and the cash you think you will receive back. The times that you expect to receive the payments must also be estimated. Each cash transaction must then be discounted by the opportunity cost of capital over the time between now and when you will pay or receive the cash.

For example, if inflation is 6%, the value of your money would halve every ±12 years. If you are expecting an asset to give you an income of $30.000 a year in 12 years time, that income stream would be worth $15.000 today if inflation was 6% for the period. We have just discounted the cash flow of $30.000: it's only worth $15.000 to you at this moment.

DCF is an approach to valuation, whereby projected future cashflows are "discounted" at an interest rate (also called: "rate of return"), that reflects the perceived riskiness of the cashflows. The discount rate reflects two things:

1. The time value of money (investors would rather have cash immediately than having to wait and must therefore be compensated by paying for the delay)
2. A risk premium that reflects the extra return investors demand because they want to be compensated for the risk that the cash flow might not materialize after all.

History: DCF was first formally articulated in John Burr Williams' 1938 text 'The Theory of Investment Value' after the market crash of 1929 and before auditing and pubic accounting were mandated by the SEC. As a result of the crash, investors were wary of relying on reported income, or indeed, any measures of value besides cash. Throughout the 1980s and 1990s, the value of cash and physical assets became steadily less well correlated with the total value of the company (as determined by the stock market). By some estimates, tangible assets dropped to less than one-fifth of corporate value (intangible assets such as customer relationships, patents, proprietary business models, channels, etc. comprising the remaining four-fifths).
 

Book: S. David Young, Stephen F. O'Byrne - EVA and Value-Based Management: A Practical Guide to Implementation

Book: Aswath Damodaran - Investment Valuation: Tools and Techniques for Determining the Value of Any Asset

Book: James R. Hitchner - Financial Valuation: Applications and Models

Compare with Discounted Cash Flow: Net Present Value  |  Payback Period  |  IRR  |  Management buy-out  |  Economic Margin

More valuation methodologies

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