The discounted cash flow method has a place in just about every finance professional's toolbox. Discounted cash flow allows you to express any investment as a single number, the equivalent to its cash value today. Investors, analysts and corporate managers apply it to all kinds of investments: individual, such as stocks or bonds; and business, including acquisitions and expansions. For all the advantages it offers, however, there are some well-recognized dangers.
How the Method Works
A quick look at how the discounted cash flow method works makes it easier to understand its strong and weak points. You start by projecting the cash flow you expect an investment to produce for each year going forward. You then discount each year's estimated cash flow to present value. That means you express the future amount in "today's dollars" using a discounting formula. Add up all the years' discounted cash flows, subtract any upfront costs, and you're left with the net present value of the investment -- what the investment is worth in today's dollars.
A Single Value
A big advantage of the discounted cash flow model is that it reduces an investment to a single figure. If the net present value is positive, the investment is expected to be a moneymaker; if it's negative, the investment is a loser. This allows for up-or-down decisions on individual investments. Further, the method allows you to make choices among significantly different investments. Project each investment's cash flows, discount them to present value, add them up, and compare them. The one with the highest net present value is the most profitable alternative.
Accuracy and Reliability
Corporate finance textbook authors Jonathan Berk and Peter DeMarzo say that using discounted cash flow to reduce investments to net present value is "the most accurate and reliable" method there is for making investment decisions. Provided that the estimates that go into the calculations are more or less correct, no other method does as good a job at identifying which investments produce maximum value.
Vulnerable to Estimation Errors
Discounted cash flow valuation is only as good as the estimates that go into it. If those estimates are flawed, the net present value will be inaccurate, and you may make bad investment decisions. The model offers multiple opportunities for error. All projected cash flows are just that: projections. They're estimates -- educated guesses. Plus, the discounting formula used to convert those cash flows to present value includes another estimate -- the discount rate, which is the rate by which you assume a certain sum of money will change in value over time.
No "Real World" Link
The discounted cash flow method produces a number in isolation. But you'd be wise not to look at that number in isolation. Say you're trying to estimate the value of a company. You can use the discounted cash flow method to come up with a value for the company. You can test how realistic that number is by performing a reality check, looking at how the value derived from discounted cash flow compares with the company's market capitalization; with the book value of the company as shown on the balance sheet; or with the value of similar companies. Berk and DeMarzo note that while about three out of four companies use net present value in making investment decisions, they often use it in combination with other methods of analysis.