Discounting cash flows (DCF) is a valuation method used by investors and management accountants to assess the appropriateness and attractiveness of investments. DCF analysis relies on the selection of a discount rate that is reasonable for the company or the investor. Determining a reasonable rate is the most difficult part of DCF analysis.
Discounting Cash Flows
DCF analysis allows an investor or a company's accountant to look at a stream of future cash flows from an investment and discount them back to the current period. The time value of money states that, because of depreciation, a dollar in the future is worth less than a dollar received today. Therefore, the future cash flows are worth less the farther out into the future they are and must be discounted back into the equivalent cash today. For example, if an investment will pay $100 a month for five years, it is worth less than the $6,000 it pays out over the course of the investment.
Uses of DCF
The most useful feature of DCF analysis is that it allows investors to compare potential investments that have different streams of cash flow. For example, if an investment pays dividends of $50 annually per share, and another pays $75 in interest every six months, DCF analysis can be used to compare the present value of those investments. The investment with the highest present value compared to the cost of the investment is considered the more attractive option.
Determining the Discount Rate
There are many ways to choose the discount rate to use in DCF analysis. The choice of the rate is the most critical input into the analysis; the choice of an unreasonable rate can skew the investment decision. The most often used discount rate is the weighted average cost of capital (WACC) to the company. This rate is defined as the rate a company would have to pay for an investment based on the type of funding it will have to use to invest. For example, if a company plans to invest in new manufacturing equipment, and plans to raise the capital through a preferred share offering and a bank loan, the WACC is the blended rate that will have to be paid in dividends and interest on the investment. From an investor's perspective, the WACC is the rate of return the investor requires for the investment will be worthwhile.
The Limitations of DCF
DCF analysis is only as accurate as the numbers used to calculated it, especially the discount rate used. If an investor miscalculates the discount rate, she can be stuck with a non-profitable investment and lose money. When investors analyze the financial statements of a company to decide if its WACC is less than the overall return to the investors, it must make assumptions about the company's future income and capital investments. DCF analysis should be but only one tool used in choosing investments.
- John Foxx/Stockbyte/Getty Images