Discounted cash flow
Categories: Basic financial concepts
In finance, a discounted cash flow is the value of a net cash flow (cash inflows less cash outflows) adjusted for the time value of money. Put simply, cash flows cannot be taken at their nominal value because a variety of risks, both endogenous and exogenous, have to be factored into project evaluation, and the influence of these risks multiplies over time. One way to account for these risks is to use the Weighted Average Cost of Capital, or to account for the opportunity cost of employing capital in a particular project. Establishing which discount rate to use is a topic in itself, and can sometimes prove to be a very complicated task.
Math
In mathematical terms, discounted cash flow is expressed as
<math>DCF = \left (\frac{1}{(1+d)^n}\right) * CF </math>, where
- DCF is the discounted cash flow, or CF adjusted for the perceived riskiness of future receipts;
- d is the discount rate, which is the risk factor (or the time value of money);
- n is the number of discounting periods used. I.e. if the receipts occur at the end of year 1, n will be equal to 1; at the end of year 2, 2—likewise, if the cash flow happens instantly, n becomes 0, rendering the expression an identity.
History
Promoted informally after the market crash of 1929, discounted cash flow was first formally articulated in John Burr Williams' 1938 text 'The Theory of Investment Value' at a time before auditing and public 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 (knowledge assets such as customer relationships, patents, proprietary business models, channels, etc. comprising the remaining four-fifths).