Getting Started With Discounted Cash Flows

Real estate. Real estate is another area where DCF calculations are popular. If you're a "flipper" (someone who buys properties to quickly fix up and sell for a profit), then you're doing yourself a major disservice if DCF doesn't come into your decision-making process.

DCF Recap: My $1 Loan Example

Let's go back to my $1 loan. How did I determine that 10 years from now I'd only have 51 cents? (To avoid brain strain, you can use TheStreet.com's Future Value Calculator.)

Because my friend will be repaying me with $1 in 10 years, the future cash flow to me is just $1.

To determine the discount rate (or rate of return , per the calculator), I had to consider two things: inflation and the interest I'd be missing out on. With U.S. inflation currently around 2.5% (according to the C.I.A. World Factbook), and my savings account paying out 4.5%, I'm missing out on 7% annually. That's my discount rate. We'll compound annually for simplicity's sake, which would mean 10 periods. So, taking the equation I showed you earlier, my equation will look something like this:

Granted, this is a very simple example. If you want to learn more complex DCF computations, make sure to check out the homework at the end of this article.

DCF valuation can be a fantastic tool to determine what an investment is worth in today's money. But that doesn't mean that it's without its pitfalls -- bad assumptions and projections can break the benefits of calculating DCF. When used correctly, discounted cash flows can really add a lot to your investment decision process.