Discounted Cash Flow
When considering any investment, we must determine a fair price to pay for it.
One strategy is to use Discounted Cash Flow (DCF) to value an investment today based on its expected cash generation in the future, i.e. its future cash flows.
Concept
A simpler way to understand DCF would be:
“If I am reasonably confident this investment will give me $X 1 year from now, 2 years from now, etc., then what’s the worst, highest price I should pay for that right now?”
However, these $X future cash flows you expect are your “educated guesses”.
Incorrect guesses will make DCF less useful apart from testing assumptions.
Garbage in, garbage out.
DCF works best with stable, predictable assets that you understand well.
Limitations
Basically, DCF attempts to value an investment as if it were a bond, except using cash flows instead of coupon payments.
The cash flow assumption can make it unreliable for certain investments.
For example, there’s only a handful of stocks with predictable cash flows.
It would be hard to use DCF to accurately model certain investments such as cryptocurrency or emerging technologies that have too many unknown variables.
Formula
To calculate DCF for an investment, you need a discount rate and a series of cash flows you are requiring the investment to generate for each year in the future, up until a specific year or to infinity.
\[DCF = \frac{CF_1}{(1 + r)^1} + \frac{CF_2}{(1 + r)^2} + ... + \frac{CF_N}{(1 + r)^N}\]where \(CF_N\) is the expected cash flow on year \(N\) from the current year and \(r\) is the discount rate.
The discount rate is introduced as a penality for the time value of money, i.e. money earned a year from now is worth less than the same amount earned today.
Net Present Value (NPV)
Net Present Value simply subtracts the upfront cost of an investment from the DCF.
If the NPV is positive, that value is the estimated profit you could make from the investment.
If the NPV is negative, that value is the estimated loss you could incur from the investment.
References
Discounted Cash Flow (DCF) Explained with Formula and Examples - Investopedia
https://www.investopedia.com/terms/d/dcf.asp
Discounted cash flow - Wikipedia
https://en.wikipedia.org/wiki/Discounted_cash_flow