Discounted cash flows (DCF) and Net Present Value (NPV) are terms often used in corporate finance but what do they mean and what are they used for?

Discounted Cash Flows (DCF)

DCF is a valuation method that estimates the value of an investment or asset by using its expected future cash flows. It is an attempt to quantify the value of an investment or asset today by estimating how much money that investment will generate in the future. It is a common method in the income approach of company valuation and is also often used by companies to assess projects/investments.

• The first step in a discounted cash flow analysis is to calculate the cost of the investment and the cash flow it is likely to generate.
• The second step is to discount the cash flow to reflect time value of money. The time value of money simply means that a euro today is worth more than a euro tomorrow because you can invest it today and start earning a return immediately.

In order to discount a discount rate must be chosen. Usually, this is the weighted average cost of capital. Put simply this is the average return an investor expects per year from an investment.  

Net Present Value (NPV)

Net Present Value (NPV) is the sum of the discounted cashflows less the cost of the investment. DCFs and NPVs are typically used to assess and compare investments or capital projects.

Let's take a simple example to explain the concept.

A company has two prospective capital projects both costing €100,000 and both of which will generate cash flows of €250,000 (net €150,000) over 5 years. The company’s minimum expected average return is 5% so this is the discount rate used. Although both projects generate the same cashflow Project 1 generates the returns earlier than Project 2 and hence has a higher NPV (€114,364 v €112,439). On this basis, the company would choose to invest in Project 1.

The table below shows the analysis:

Such an analysis provides a company with  a useful tool for assessing or comparing projects or investments  – but it is only an estimate – the cash flows are estimates underpinned by assumptions and the discount rate is an estimate and as such should always be treated with caution. The same principles can be applied to a company valuation – by discounting future cash flows a value may be put upon the company This is a useful means of valuation but again is subjective and dependent upon estimated cash flows and discount rates.