A discounted cash flow model is a tool companies use to determine the attractiveness of investment and business opportunities. The model requires an estimation of all future cash flows for a specific time period for the investment. The firm then discounts the sum of these cash flows back to current dollar value. This requires the use of the weighted average cost of capital, which is the cost of borrowing money for the new opportunity. Higher discounted cash flows than the investment cost represent a profitable opportunity.
The discounted cash flow model allows for a thorough analysis of new investments. Companies can use this tool whenever they estimate future cash flows. This makes the model widely usable for different types of projects, strengthening the purpose of the tool. Almost all companies use it. Large firms have a corporate finance department or finance analyst to review investments and opportunities using discounted cash flows.
A basic discounted cash flow model formula is the cash flow for year one divided by one plus the cost of capital raised to the power of one. This formula is the same for each subsequent year, with the only difference being that the divisor is raised by the power of two, three, and so forth, for each year. The sum of these figures then represents the total expected cash flows discounted to current dollars. The purpose of this formula is to strip the time value of money out of future dollars so companies can make an apples-to-apples comparison.
Estimating future cash flows for new opportunities that will continue in perpetuity can be difficult. Companies most often select a few years for each new investment to measure the strength of the new opportunity. For example, the first five, seven, or ten years is a common measurement. This provides the firm with a measurement that at least allows the company to determine how long it will take to pay back the initial cost of the investment. The discounted cash flow model works best with shorter time periods.
The discounted cash flow model is not without flaws. Because cash flow estimates are necessary, this can result in bad information plugged into the model. The resulting calculation is then skewed, leading to potentially incorrect decisions. Owners and managers must make the best estimates possible in order to present the most accurate results when using the discounted cash flow model.