What is Discounted Cash Flow?

Understanding when to use and how to calculate discounted cash flow.

Discounted Cash Flow is a tool that can be used to determine whether an investment is worth investing in. It can be used when looking to invest in projects, assets, stocks or any investment that produces a cash flow.

The method of calculation is based on projected future cash flows discounted to take into account the time value of money. The time value of money operates under the assumption that £1 today is worth more than £1 in the future if money today can earn interest.

Receiving cash flow as cash after 1 year is not as valuable as getting the money today as it won’t have had the benefit of a year’s interest from investment so needs to be discounted in order to accurately reflect its current day value.

How does discounted cash flow work?

Discounted Cash Flow works by calculating the present value of an investment using discounted projected future cash flows to determine whether the investment is worthwhile.

To use this method, the investor must be able to make reasonably accurate estimates regarding future cash flows and also be able to choose a discount rate that will accurately reflect the time value of money for the period that the investment will be in operation.

The present value of the discounted cash flow calculated will likely be higher or lower than the initial investment therefore providing the investor with a valuable measure regarding the profitability of moving forward with an investment project.

Discounted Cash Flow Calculation

DCF= CF1/(1+r) + CF2/(1+r)2+ CF3/(1+r)3+....CFn/(1+r)n

DCF = Discounted Cash Flow

CFn = Projected cash flow where n=year (1,2...n)

r = Discount rate (e.g. a rate of 5% gives r=0.05)

What are the advantages and disadvantages of discounted cash flow?

Advantages of discounted cash flow:

  • Discounted Cash Flow reduces an investment opportunity to a single figure that represents its future value in the present day. This makes it easier to make comparisons between significantly different investments
  • If an analyst is confident about the assumptions being made regarding cash flow this method is likely to be more accurate than other methods as it takes into account earnings over the lifetime of a project plus applies a discount rate to make the current day value more realistic
  • The techniques are relatively simple to understand compared to other methods
  • Advisable to be used as one of many other methods to develop a full understanding of a stocks value

Disadvantages of discounted cash flow:

  • If there are low levels of confidence in future cash flow predictions the valuation arrived at will give an inaccurate prediction of the future success of the investment
  • The calculation used is very sensitive to changes in estimates, both cash flow and discount rates, which can have a significant effect on the final valuation
  • A lot of assumptions have to be made which make it prone to errors when estimating future cash flows and determining an appropriate discount rate
  • The discount rate used is fixed throughout the life of the project which may not reflect the future value of today’s money
  • Not advisable to make decisions based on this one method alone

Have you thought about Invoice Finance as a cash flow solution for your business?

Invoice finance allows you to release cash quickly from your unpaid invoices.

As your lender, we can release up to 90% of your invoices within 24 hours. On payment of the invoice from your customers, we will then release the final amount minus any fees and charges. There are different types of invoice financing options available to businesses depending on the situation and the level of control they require in collecting unpaid invoices.

We are an invoice financing company who offer a solution whereby payments are collected on your behalf managed by our team of expert credit controllers so you can focus on running your business. Our Confidential Invoice Discounting solution is offered to businesses who want to maintain their own credit control processes, therefore this remains strictly confidential so your customers are unaware of our involvement.

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The benefits of invoice finance companies such as Novuna Business cash flow

  • Boost your cash flow without having to wait up to 120 days for your customers to pay you

  • Release up to 90% of the invoice straight away, and the final 10% when the invoice is settled

  • Access funds within 24 hours from initial appointment with our revolutionary digital onboarding process

  • Benefit from our in-house credit control processes, allowing you to focus on running your business, instead of chasing clients for payment

  • 6 month trial period followed by a rolling contract

Want to understand more Cash Flow Finance terms?

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We explore ways you can begin improving your cash flow situation and start getting your business on track to positive cash flow.

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