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 does this by adjusting those future amounts for the fact that money in your pocket now is worth more than the same amount received in a 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? Below, we cover the discounted cash flow formula, a worked example, how to pick a discount rate and how to use DCF to make better decisions about your business.

What is discounted cash flow?

Discounted cash flow is a valuation method that estimates the value of an investment, project or business based on its expected future cash flow. Unlike methods that only look at current profit or asset values, DCF factors in the time value of money, the idea that £1 today is worth more than £1 in the future because it can be invested, and because inflation and risk erode its value over time.

DCF is used for all sorts of decisions, including:

• Valuing a business before buying, selling or investing in it

• Deciding whether to invest in new equipment, premises or a new product line

• Comparing two or more possible projects to see which creates more value

• Supporting a business plan when raising investment or applying for funding

The discounted cash flow formula

The discounted cash flow formula takes each expected future cash flow and divides it by a discount factor, so you can see what that cash is worth in today's money. Add up all of those discounted amounts, plus a terminal value for anything beyond your forecast period, and you have your DCF.

The formula is:

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

Here is what each part means:

In plain terms, every pound you expect to receive in future gets discounted a little more for every year you have to wait for it, and for every bit of extra risk attached to it.

Worked example: how to calculate discounted cash flow

Say a business is deciding whether to invest £200,000 in new machinery. It expects the following free cash flow over the next four years, and is using a discount rate of 10 percent to reflect its cost of capital and risk.

Adding up the present values gives a total discounted cash flow of roughly £212,025. Since this is higher than the £200,000 cost of the investment, the numbers suggest the machinery is likely to add value to the business, once the time value of money and risk have been accounted for.

This same approach works whether you are sizing up a piece of equipment, a new location, or the purchase of an entire business, the only things that change are the size of the cash flows and the length of the forecast.

How to choose a discount rate

The discount rate is the part of the formula that has the biggest effect on the result, so it is worth getting right. It should reflect how risky your cash flows are and what return you or your lenders would expect for taking that risk on. As a general guide for UK businesses:

If your business already knows its weighted average cost of capital, known as WACC, this is often used as the discount rate for company wide investment decisions. WACC blends the return expected by shareholders with the interest paid on any debt, weighted by how much of each makes up your funding. Smaller businesses without a formal WACC often use a simpler build up approach instead, starting from a risk free rate and adding on premiums for company size, sector risk and how dependent the business is on one or two key people.

What is terminal value and how is it calculated

Most DCF calculations only forecast cash flow in detail for three to five years, since forecasting further out becomes unreliable. Terminal value is used to capture everything the investment or business is expected to be worth beyond that point. There are two common ways to calculate it:

• Perpetuity growth method. This assumes cash flow keeps growing at a steady, modest rate forever after the forecast period. It works well for stable, mature businesses.

• Exit multiple method. This assumes the business or asset is eventually sold, and applies a multiple based on what similar businesses have sold for. It is often used when a sale or exit is genuinely likely.

Because terminal value often makes up a large share of the total DCF result, it is worth testing a few different assumptions rather than relying on a single number.

Discounted cash flow vs net present value

Discounted cash flow and net present value, or NPV, are closely related but not quite the same thing. DCF is the process of discounting future cash flows back to their value today. NPV is what you get when you take that discounted total and subtract the upfront cost of the investment.

Put simply, DCF tells you what the future cash is worth today, while NPV tells you whether the investment is worth making once the initial cost is factored in. A positive NPV suggests an investment is expected to add value, while a negative NPV suggests it may not be worth the initial outlay.

Why discounted cash flow matters for your business

DCF gives you a way to compare decisions on equal terms, rather than relying on gut feel or looking only at short term numbers. It is particularly useful when:

• You are weighing up whether to buy another business, and want to check the asking price against what future profits actually justify

• You are deciding between two capital projects and need to know which one creates more value

• You are putting together a cash flow forecast to support a funding application or investment pitch

• You want to understand how sensitive a decision is to risk, by adjusting the discount rate up or down

Because DCF forces you to be explicit about your assumptions, cash flow, growth, risk and time, it also makes it easier to spot when a deal or project only looks good because of overly optimistic numbers.

Advantages and limitations of discounted cash flow

How to use discounted cash flow for your business

To get the most reliable result from a DCF calculation:

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

• Reflect the specific risks your business faces, such as customer concentration, competition, regulation or reliance on key staff, in your discount rate

• 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 the market you operate in

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

Looking to boost your cash flow?

Once your discounted cash flow calculation shows an investment is worth making, the next question is usually how to fund it. At Capitalise, we work with a panel of 130+ lenders to help match your business with the right type of funding, whether that is for new equipment, a business acquisition or growth capital.