Discounted cash flow

Developed by Oliver Skou Schwarz

This page refers to the discounted cash flow (DCF) method regarding projects and investments. Discounted Cash Flow (DCF) is a method used to estimate the value of an investment or a project by projecting its future cash flows and then discounting them back to their present value. The reason for using DCF is that an investment's value is equal to the sum of its expected future cash flows, discounted at an appropriate rate to account for the time value of money and the investment's level of risk. The sum of the discounted cash flow is the Net Present Value (NPV).

History

Origin

• Origin of the method
• Why was it "invented"?
• Who "invented" it?

The concept of discounted cash flow (DCF) has been used in various forms for centuries, but the modern version of DCF used in finance and investment analysis can be traced back to the early 20th century.

One of the earliest uses of DCF in its modern form was by Irving Fisher, an American economist, in his 1930 book "The Theory of Interest." Fisher used DCF to calculate the present value of a stream of future cash flows, which he called the "net present value" of an investment.

Fisher's work on DCF was groundbreaking and became an important part of finance theory. Since then, DCF has been widely used in financial analysis and valuation, including in corporate finance, investment banking, and portfolio management.

Use throughout history

How has it been used before?

• In the 1930s, DCF was used by economists such as Irving Fisher and John Maynard Keynes to analyze the impact of interest rates on investments and economic growth.
• In the 1950s, DCF gained popularity in the oil and gas industry as a tool for valuing oil and gas reserves. This was known as the "net present value" (NPV) method, which calculates the present value of expected cash flows from oil and gas reserves.
• In the 1960s and 1970s, DCF was used by corporate finance professionals to evaluate capital investment projects and to value businesses for mergers and acquisitions.
• In the 1980s and 1990s, DCF became widely used in the field of equity research, where it is used to value stocks and make investment recommendations to clients.
• Today, DCF is still widely used in all of these areas, as well as in other fields such as real estate investment and project finance.

Overall, DCF has been an important tool for investors, analysts, and managers in making informed decisions about investments, capital allocation, and strategic planning.

Math section

A section describing the mathematical expression in detail, so it is broken down into understandable parts. Including examples of how the calculation method works.

• Discounted Cash Flow (formula)
• Free cash flow
• Discount Rate

Application

A section explaining how and when to use the method, and what it is used with

Time value of money

The time value of money refers to the concept that monetary value changes over time. Practically, this means that an equal amount of money available at different points in time has different values due to many various factors such as changing inflation and interest rates.

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The general concept is that money available today is worth more than the same amount of money available in the future, because it can be invested smartly or used immediately to generate returns. On the other hand, money available in the future is worth less than the same amount of money available today, because it cannot be used or invested until that future time.

Therefore, the time value of money is an important concept in project work and when investing in them, as it helps project managers and businesses make better decisions about how to allocate their resources in the right points in time.

Free Cash Flow

The free cash flow (FCF) is the cash flow that is available to equity holders and debt holders after a business pays for the costs of continued operations, like operating expences and capital expenditures. Generally, the more free cash flow a business or a project has, the more attractive it will be for investors, as it will be able to invest in new opportunities. There are multiple ways of calculating the free cash flows depending on the level of precision and complexity. A simple model for calculating this can be seen below.

$F C F = Sales Revenue - (OPEX + Taxes) - CAPEX$

The sales revenue is the money going into the project or the business, hence the positive sign.

The Operational Expenditure (OPEX) refers to the recurring short-term cost of maintaining the operations of a project or a company on a daily basis. This could be the cost of necessities such as rent, electricity, staff salaries, and other costs associated with delivering a project's desired outcome on a day-to-day scale.

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Possible Sources:

https://www.investopedia.com/terms/d/dcf.asp

https://www.investopedia.com/terms/c/cashflow.asp

https://www.streetofwalls.com/finance-training-courses/investment-banking-technical-training/discounted-cash-flow-analysis/

https://www.pmi.org/learning/library/project-investment-9384

(PROJECT INVESTMENT https://esfccompany.com/en/articles/economics-and-finance/investment-project-management/)

(HISTORY https://www.jstor.org/stable/2490123?seq=8)

(TIME VALUE OF MONEY https://www.investopedia.com/terms/t/timevalueofmoney.asp)

(NET PRESENT VALUE https://www.investopedia.com/terms/n/npv.asp)

(Weighted average cost of capital WACC https://www.investopedia.com/terms/w/wacc.asp)