Getting Started With Discounted Cash Flows

Discounted cash flows are used by pros in the finance world all the time to figure out what an investment is actually worth. And while calculating discounted cash flows can be an involved process, it can also be a lucrative one as well. Here's a look at DCF valuation and how you can use it on your personal investments and finances.

What Are Discounted Cash Flows?

Think of discounted cash flows this way: they're a way of taking a payoff from an investment in the future, and putting it in terms of today's money. Discounted cash flows take into account the time value of money -- the fact that one dollar 10 years from now is worth less than $1 today.

If I loan that dollar to someone, I'm costing myself all the interest or gains that I would earn if I saved or invested it. I'm also pitting 10 years of inflation against my dollar's buying power. What that means is that when all is said and done, my dollar's only worth around 51 cents (I'll get to how I calculated that in a bit), which means that I'm losing about half of my money.

Discounted cash flows take these factors into account to calculate what a reasonable valuation is today for a company's success years down the road.

Why Use Discounted Cash Flows?

DCFs are omnipresent in the finance world -- they're used by everybody, from analysts to portfolio managers -- even Warren Buffett is known to make decisions based on discounted cash flow calculations. But why?

Discounted cash flows give investors a better picture of a company's value today because they account for what it might be worth tomorrow. You probably wouldn't buy a car without knowing what it's worth, so why would a stock be any different? Having a more relatable dollar value in front of you can help you make better-informed investment decisions.

Discounting can actually be used for more than just cash flows . Historically, cash flows have been discounted because they represent cold hard tangible assets . They're also devoid of income statement items like depreciation expenses that affect a company's income without affecting the amount of money the company has.