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How to Calculate Discounted Cash Flow

NEW YORK ( TheStreet) -- 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.

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."

It's also important to remember that numbers aren't static -- they change over time. Don't put too much stock in DCF valuations that might be out of date. A perfectly valid valuation made three years ago might not be at all in line with a company's present day value.

DCF valuations represent long-term projections, so don't fall into the trap of thinking that just because a company is supposedly overvalued it isn't a good short-term investment. Discounting cash flows mainly deals with assessing a company's fundamentals and doesn't take into account the technical issues that might send a "bad" stock's price soaring in the short run.

DCF Methods Vary

The methods used for discounting cash flows can vary depending on the type of investment you're trying to value. Here are a few popular uses for DCF.

Bonds. One of the central elements of bond valuation is the use of discounted cash flows. With the bonds, though, the numbers are a lot more concrete. Troyer says, "The bond market is essentially a giant DCF engine. It's the same way with stocks, but the numbers aren't as scientific." Why? With a bond, variables like number of periods, future cash flow, and discount rate (coupon in the case of a bond), are all given and don't change.

Despite the fact that the discounting of bond cash flows are generally factored into the bond's pricing, if you're into bonds , then understanding DCF is a must.

Stocks. Stocks are an area where DCF is a popular tool. The stock market is also a place where poorly thought-out DCFs can lose big money.

Stocks have added elements of confusion when it comes to DCF since they don't have the static numbers that bonds do. Because of this, calculating discounted cash flows for equities adds an extra element of risk that's actually taken into account in more complex DCF equations.

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?

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, using a future value 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.

DCF Homework

So do you want to get Buffett-like analysis skills? Here are two activities that can help you hone your ability to discount cash flows.

1. Explore Professor Damodaran's Web site. If you want to learn more advanced concepts and formulas about discounted cash flows, visit the Web site of Professor Aswath Damodaran at the NYU Stern School of Business. His site on valuation, corporate finance and investment offers lecture notes, tutorials, sample problems and worksheets that can help enhance your valuation abilities.

2. Practice with online calculators. Go to an online DCF calculator and practice making your own projections for real stocks with historical data. How do your estimates hold up? Here are a few online calculators of varying complexity:

Jonas Elmerraji is the founder and publisher of Growfolio.com, an online business magazine for young investors.

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