Discounted cash flow analysis is used to calculate the present value of an uneven cash flow stream. Uneven means the cash flow goes up or down from year to year. Cash flow is the difference between the cash coming into and leaving a business. Present value is the sum of future cash flows discounted back to the present using a discount rate, which can vary over time. Use a present value analysis to choose between alternative investments or to calculate the fair value of an acquisition target.
Choose a discount rate. The discount rate, according to University of South Carolina professor Samuel Baker, is an opportunity cost of either a minimum rate of return that the funds can earn elsewhere or the interest rate on bank loans. For example, you can use the current two-year government bond yield or the interest rate on a term loan as your discount rate. You can also add a risk premium to these rates, but as Baker notes, higher discount rates reduce the present value amount.
Tabulate the future cash flow stream. Use your company's historical performance and your assessment of future business and economic conditions to estimate future cash flows. For example, if the past five-year average cash flow is $1.5 million, and you expect it to grow 3 and 7 percent in the first and second years, respectively, then cash flow is $1.5 million in year zero (the current year), $1.545 million ($1.5 million x 1.03) in year one, and about $1.653 million ($1.545 million x 1.07) in year two.
Calculate the present value of an uneven cash flow stream. The present value is equal to the cash flow in year zero plus the sum from year one to the terminal year of CFn / (1 + r)^n, where CFn is the cash flow in year "n" and "r" is the discount rate. The terminal year is the final year of an analysis period.
For example, if you assume a discount rate of 5 percent, the present value for years zero to two is equal to $1.5 million + [$1.545 million / (1 + 0.05)^1] + [$1.653 million / (1 + 0.05)^2]. This simplifies to $1.5 million + ($1.545 million / 1.05) + ($1.653 million / 1.05^2), or $1.5 million + $1.471 million + $1.499 million, or $4.47 million. Assume that the discount rate remains constant over the analysis period to simplify calculations.