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What is Discounted Cash Flow?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 21 September 2018
  • Copyright Protected:
    2003-2018
    Conjecture Corporation
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Discounted cash flow is an approach to valuation that is useful in determining just how attractive a particular investment opportunity is likely to be for a given investor. The idea behind this type of calculation is to help an investor choose stocks, bonds, and other securities that will provide the amount of return desired within a specified period of time. By using this model to evaluate each investment opportunity, the investor stands a better chance of arranging the portfolio so that it moves the investor closer to his or her personal goals.

While there are different approaches to developing a workable discounted cash flow model, the purpose is to assess not only how much of a return can be reasonably expected from the investment, but how long it would take to earn that amount of return. As part of the process, the investor also allows for the weighted average cost of return as the means of discounting the cash flow. This is compared to the circumstances of the investor, and his or her need for a minimum amount of return within the period under consideration. If the projection of the discounted cash flow indicates that the investor will recoup the investment and begin to see a return within a reasonable period of time, then the investment is likely to be a good option.

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This process of identifying the time value of money earned from the investment can be especially important if the idea is to create a steady flow of income. Choosing investments that are highly likely to produce returns that can be counted upon for receipt within a given time frame may be very important to the investor, especially if those returns are slated for use in meeting basic living expenses. Thus, the process of assessing the discounted cash flow associated with a given investment becomes crucial to the creation and the maintenance of a workable budget.

Depending on the complexity and range of circumstances associated with a given investor, determining the discounted cash flow may be a very simple process, or one that must allow for a number of different factors. In situations where the investors is a large corporation, the process of calculation may be somewhat more involved, while an investor who is simply looking to project the return that can be used for income over the next six months will have fewer factors to consider. In any event, the calculation of the discounted cash flow can help investors avoid committing to investments that are less likely to help them achieve their goals, and identify investments that demonstrate a high level of potential to aid them in reaching the desired results.

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