Getting Started With Discounted Cash Flows

How Do You Discount Cash Flows?

Word to the wise: discounting cash flows involves math -- and a fair amount at that. One of the most basic formulas for discounted cash flows is a present value calculation:

The discount rate mentioned in the formula is the opportunity cost (time value of money) -- in the case of my dollar loan, it's the inflation and lost interest that made my dollar worth so much less 10 years after I lent it. In the case of stocks, the discount rate is typically the cost of the company's capital .

It gets a little trickier for multiple periods. But never fear, for those of us who aren't "mathemagicians," there are a plethora of online calculators (some of which you'll find in the homework section of this article) that allow you to drop in your numbers in order to calculate the present value of your cash flows.

How to Avoid Common DCF Mistakes

Discounting cash flows can be tricky. Remember, you're using estimates here for future numbers, so "bad" or unreasonable estimates can mean worthless numbers. According to Jim Troyer, a Principal at The Vanguard Group, these future projections are one of the biggest snags for investors new to DCF. "There are two main things people do," Troyer says, "make assumptions at random, and project the past into the future." Troyer describes these mistakes as "blind trend projection" and "inconsistent assumptions."

Troyer warns investors: "Most firms can't grow faster than the economy forever. When you use discounted cash flows, it's important not to project too strong of growth rate too far out. A very small change in something like the discount rate can have a huge affect on present value."