What is discounted cash flow? The DCF formula and how to calculate it

Discounted cash flow (DCF) is a way of working out what an investment or business is worth today, based on the cash it is expected to generate in the future. It reduces each future amount to reflect the fact that money in your hands now is worth more than the same amount received in one year, or in five years' time. For business owners, discounted cash flow is one of the clearest ways to answer a simple question: is this investment actually worth it? This guide covers the DCF formula, a step by step calculation with a worked example, how to choose a discount rate, what terminal value is, how DCF differs from net present value and how to use it to value a business.

What is discounted cash flow?

Discounted cash flow is a valuation method that estimates the value of an investment, project or business from its expected future cash flow. Unlike methods that only look at current profit or asset values, DCF factors in the time value of money. This is the idea that £1 today is worth more than £1 in the future, because today's pound can be invested and because inflation and risk erode the value of money you have to wait for. Business owners use discounted cash flow to make a range of decisions:

• It helps you value a business before buying, selling or investing in it.

• It shows whether new equipment, premises or a new product line is likely to pay for itself.

• It lets you compare two or more possible projects on equal terms to see which creates more value.

• It supports a business plan when you are raising investment or applying for funding.

What is the discounted cash flow formula?

The discounted cash flow formula divides each expected future cash flow by one plus the discount rate, raised to the power of the year it arrives in. You then add up all of those discounted amounts, plus a discounted terminal value for anything beyond your forecast period.

DCF = CF₁ / (1 + r)¹ + CF₂ / (1 + r)² + ... + CFₙ / (1 + r)ⁿ + TV / (1 + r)ⁿ

Each part of the formula stands for one input:

• CF is the cash flow you expect in a given year.

• r is the discount rate, which reflects risk and the time value of money.

• n is the number of years into the future.

• TV is the terminal value, an estimate of what the investment is worth beyond the forecast period.

The discount factor for any single year is 1 / (1 + r)ⁿ, the same formula HM Treasury's Green Book uses for discounting. At a 10% discount rate, the factor for year one is 0.909, so £1 you expect to receive in a year is worth around 91p today. By year four the factor is 0.683, so the same £1 is worth around 68p today.

How do you calculate discounted cash flow step by step?

You can calculate discounted cash flow in five steps, whether you are assessing a single piece of equipment or a whole business.

1. Forecast the cash flow the investment will generate each year. A cash flow forecast built from your trading history gives you the most reliable starting point.

2. Choose a discount rate that reflects how risky those cash flows are.

3. Work out the discount factor for each year using 1 / (1 + r)ⁿ.

4. Multiply each year's cash flow by its discount factor to get its present value.

5. Add the present values together, including a discounted terminal value if the investment will keep producing cash beyond your forecast period.

The cash flow figure you use is normally free cash flow. This is the cash left after running costs and any capital spending needed to keep the business or asset going, and it usually starts from your operating cash flow.

Worked example: is a £200,000 machinery investment worth it?

Say your business is deciding whether to invest £200,000 in new machinery. You expect it to generate the free cash flow below over the next four years, and you use a discount rate of 10%. The discount factors are the standard 10% factors used in ACCA's guide to investment appraisal.

The machinery is expected to bring in £270,000 over four years, but in today's money that cash is worth roughly £212,025. Because that is higher than the £200,000 cost, the machinery is likely to add value to the business once the time value of money and risk are accounted for. If the investment stacks up, the next step is deciding how to pay for it. Spreading the cost with asset finance means the machinery can start generating cash before it has been paid for in full, rather than taking £200,000 out of your working capital on day one.

How do you choose a discount rate?

The discount rate has the biggest effect on the result. It should reflect how risky your cash flows are and what return you or your lenders would expect for taking that risk on. There is no single correct rate, but the less certain your cash flows are, the higher the rate should be. A common choice is your weighted average cost of capital, known as WACC. This blends the return your shareholders expect with the cost of your debt, weighted by how much of each makes up your funding. The interest rate on your business borrowing is therefore one of the building blocks of your discount rate.

How much does the discount rate change the result?

Small changes to the discount rate can change your answer completely. Running the same £200,000 machinery example at different rates shows how quickly a worthwhile investment can stop covering its cost.

At 8% the investment looks comfortably worthwhile. At 14% the same cash flows no longer cover the £200,000 cost. Testing more than one rate before you commit shows whether a project only looks good because of an optimistic assumption.

What is terminal value?

Terminal value is the estimated worth of an investment or business beyond the period you have forecast in detail. A business valuation usually forecasts cash flow year by year over a defined period, often five to ten years, and terminal value captures everything after that point. There are two common ways to calculate it:

• The perpetuity growth method assumes cash flow keeps growing at a steady, modest rate forever, and it works best for stable, mature businesses.

• The exit multiple method applies a valuation multiple, such as a multiple of EBITDA, to the final forecast year, and it is often used when a sale is likely.

Terminal value often makes up a large share of the total DCF result, so it is worth testing a few different assumptions rather than relying on a single number. A machine with a fixed working life, like the one in the example above, has no terminal value beyond any resale value at the end.

What is the difference between discounted cash flow and net present value?

Discounted cash flow tells you what future cash is worth today. Net present value (NPV) takes that figure and subtracts the upfront cost, which tells you whether the investment is worth making. In the machinery example, the DCF is £212,025 and the NPV is £12,025 after taking off the £200,000 cost. A positive NPV suggests an investment is expected to add value, while a negative NPV suggests it may not be worth the outlay.

How is discounted cash flow used to value a business?

Discounted cash flow values a business on the cash it is expected to generate in future, rather than on its past profits or the assets on its balance sheet. You forecast the business's free cash flow, discount it at a rate that reflects the risk of the business, then add a discounted terminal value. The total is an estimate of what the whole business is worth today. This makes DCF particularly useful if you are buying another business and want to check the asking price against what its future cash flow can justify. Lenders look at the same question when you apply for a loan to buy a business, because the target's future cash flow is what will repay the borrowing. Buyers and advisers often compare a DCF value with a multiple of EBITDA. If the two sit far apart, it is a sign to revisit the assumptions behind your DCF.

What are the advantages and limitations of discounted cash flow?

The main advantage of discounted cash flow is that it values an investment on the cash it will actually generate, adjusted for time and risk. Its main limitation is that the result is only as good as the assumptions behind it.

The advantages of discounted cash flow include:

• It accounts for the time value of money, not just current profit.

• It works for almost any investment, business or project.

• It forces clear thinking about growth, risk and returns.

The limitations of discounted cash flow include:

• It relies heavily on the accuracy of your future cash flow forecasts.

• Small changes in the discount rate can significantly change the result.

• It is less reliable for new or fast changing businesses with unpredictable cash flow.

• Terminal value often makes up a large share of the total, which adds uncertainty.

How can you make your DCF calculation more reliable?

These habits will give you a more reliable result:

• Base your cash flow projections on your actual trading history, market conditions and known costs rather than best case thinking.

• Use a higher discount rate where your cash flows are less certain.

• Test more than one scenario so you can see how the result changes if growth is slower or the discount rate is higher than expected.

• Revisit your DCF as circumstances change, since a calculation done a year ago may no longer reflect your current cash flow or market.

• Use it alongside other measures, such as your working capital position, rather than as the only input into a decision.

Fund the investment your DCF says is worth making

Once your discounted cash flow calculation shows an investment will pay for itself, the next question is how to fund it without putting pressure on your day to day cash. A business loan lets you spread the cost of new equipment, premises or an acquisition over the period it generates a return. Capitalise works with a panel of 130+ lenders, so you can compare business loan offers matched to your business and the investment you are planning, all in one place.