Discounted cash flow: what it is, how it’s calculated

The financial toolkit for small business owners is packed with metrics and methods designed to help you succeed. One key tool is discounted cash flow (DCF), which helps in several important business areas, including:

• Evaluating potential returns from projects and investment

• Mapping out the growth of your business

• Figuring out how to value a business accurately

Given the importance of discounted cash flow analysis and the insights it can offer, taking time to understand how to use this financial tool is a good move.

Given the importance of discounted cash flow analysis and the insights it can offer, taking time to understand how to use this financial tool is a good move. 

However, not knowing how to use discounted cash flow can lead to costly mistakes, like putting the wrong value on investments, which can mess up your financial strategy and hinder any thoughts of how to scale a business.

In this guide, we’ll break down the concept of discounted cash flow and show how this tool can reveal the true value of the cash you have today. By the end, you’ll not only understand how discounted cash flow analysis works but also learn some practical ways to apply it in your business.

What is discounted cash flow?

So, what is the discounted cash flow method exactly? Put simply, DCF calculates how much a business or investment is worth based on the cash it’s expected to generate in the future.

Discounted cash flow is rooted in the concept of the time value of money – the idea that money available today is worth more than the same amount in the future. That’s because money you have now can be invested to grow, while future money is less certain and doesn’t earn extra.

So, when making financial decisions, timing matters as much as the amount.

Knowing how to calculate discounted cash flow is invaluable whether you’re brainstorming how to price a product, thinking up online business ideas, or looking at the returns from investing in new technology. DCF can guide you in where best to allocate resources and make your decisions much more effective.

How to calculate discounted cash flow

Calculating discounted cash flow involves using a specific formula. This converts future cash flows to their present value using a discount rate.

Here’s what it looks like:

There’s no denying the discounted cash flow formula appears complicated at first glance, so let’s break it down and look at its three main components in more detail:

• Cash flow in the period (CF)

• The interest or discount rate (r)

• The period number (n)

Cash flow in the period

These are the net cash flows you expect to receive in future periods – annually, quarterly, or monthly, depending on your needs. Cash can flow into your small business from various sources:

• Revenue from products or services sold – including all income from your day-to-day business operations, such as from things to make and sell, or payments for services you provide.

• Savings from cost improvements – such as from introducing more efficient business practices, reducing material costs, or improving small business cyber security measures to cut expenses.

• Other income streams – including any additional money from activities outside your main business, such as rental income from property or earnings from side hustle ideas.

Remember, calculating net cash flows involves subtracting regular operating expenses, such as rent, utilities, wages, and raw materials from these cash inflows. 

When using the DCF formula, you also need to consider whether you’re evaluating the potential returns from a specific project or an entire business.

For a specific project

When focusing on individual projects, you should calculate the cash flows directly related to the projects in question, considering how they impact revenues and costs specifically.

For example, let’s say you’re in the food and drink business and you’re considering adding a new line of gourmet sandwiches to your menu. In this scenario, you would analyse the additional revenue expected from sandwich sales. You must also factor in the cost of extra ingredients, additional staff, and any necessary kitchen or shop upgrades.

The net cash flow for this project is the difference between the increased revenue from selling the sandwiches and the total extra costs of producing them.

For valuing an entire business

To value an entire business using the DCF formula, you include all cash flows from every part of the business. This allows you to work out the overall value or financial health of your business, helping you make informed decisions about where to invest or cut back.

For instance, if you operate a hospitality business like a hotel, you might consider cash inflows from sources like room rentals, restaurant and bar operations, event hosting, and spa services, along with regular outflows relating to overheads – not forgetting to factor in savings from operational efficiencies like automated booking systems.

The discount rate

The discount rate, or the interest rate, is how you adjust future cash flows to their present value to show what they’re worth right now.

This rate often reflects the Weighted Average Cost of Capital (WACC) – essentially the average interest rate your business pays on its borrowed funds. It combines the cost of debt (such as loans) with the expected returns owed to investors, ensuring that the money you invest in projects earns enough to at least cover these costs.

Even if your business doesn’t have shareholders or debt to consider, knowing how to apply discount rates to cash flows accurately is essential for DCF analysis. Here are a few tips on doing that:

• Consider the typical discount rates used in your industry, as these rates are what are generally considered good returns for the risks involved. You can often find this information in industry reports, financial news sources, business journals, or through trade associations.

• Conduct risk assessments of your investments. For high-risk business opportunities, such as entering new markets or launching startups, opt for a higher rate. Effective small business risk management accounts for the uncertainty and potential volatility of investments, ensuring that the projected rewards justify the risks.

Consult financial advisors. They will have a thorough knowledge of complex financial details and can help you choose the right discount rate, based on the risk involved and your goals. This advice can be really helpful when you’re dealing with complex investments or big changes in how your business operates.

The period number

The period number in discounted cash flow analysis represents the timeframe over which you expect cash flows to come in.

Choosing the right number of periods is a key part of getting DCF analysis right, as it affects how far into the future you project cash flows before discounting them back to their present value.

In the discounted cash flow formula, CF1 is the cash flow in the first period, CF2 in the second, and so on, continuing up to CFn in the nth (final) period.

Typically, DCF calculations span between five and 10 years, covering the expected payoff phase for many investments. However, shorter timeframes may be suitable for projects that realise returns faster.

The length of the periods used can vary; some might be the same length, and others might be expressed as percentages of a year to match specific cash flow timings.

Estimating terminal value

After checking out the initial cash flows of your project or business, you might also consider estimating its terminal value.

This calculation helps you assess the potential future income which your investment could generate beyond your initial forecast period. It’s particularly useful for evaluating the long-term benefits of substantial investments.

There are two main ways to calculate terminal value:

• The perpetual growth method, which assumes that cash flows will continue growing at a consistent, fixed rate indefinitely. It’s ideal for projects expected to offer stable, long-term returns.

• The exit multiple method, which applies a standard industry multiplier to an important financial figure from the last year of your projection, such as net income or cash flow. It estimates the potential market value of your project at the end of the forecast period.

Discounted cash flow example

Let’s see how DCF works in practice using a straightforward scenario.

Imagine you’re considering second income streams for your small dry cleaning business. You’re good at sewing and think about buying a sewing machine to offer simple repair services.

The machine costs £1,000, and you choose a 10% discount rate, which might reflect the minimum profit you expect from your investments or align with the cost of capital.

You expect net cash flow from repairs to increase annually – starting at £600 in the first year, rising to £800 in the second, and reaching £1,000 by the third.

Here’s what the formula looks like:

Breaking down the calculations by year, we get:

• Year 1 – £600 discounted by 10% (£600/1.10) is approximately £545.45

• Year 2 – £800 discounted by 10% for two years (£800/1.21) = £661.16

• Year 3 – £1,000 discounted by 10% for three years (£1,000/1.331) = £751.31

Adding up these values gives us the total present value of £1957.92. This means the future revenue from the sewing machine is worth about £1957.92 today, suggesting a sound investment.

Calculating net present value

For a different view of the potential profitability of investments, you can calculate net present value (NPV) by subtracting the initial cost of the investment from the discounted cash flow.

For example, with the sewing machine:

NPV = £1957.92 - £1,000 (£957.92)

To compare, if you put £1,000 in a savings account with a 5% annual interest rate, it would grow to about £1,157.63 in three years, offering a gain of £157.63.

Investing in the sewing machine (netting £957.92) seems more lucrative. However, you need to remember that unlike passive income ideas, like earning interest on savings, running the repair service requires active involvement.

You will need to spend time doing repairs, or maybe even consider how to hire employees to help with the extra workload.

Tools for DCF calculations

If manual calculations aren’t your thing, there are some straightforward accounting tools for small business entrepreneurs which can make discounted cash flow analysis much easier:

• Microsoft Excel and Google Sheets – these widely-used spreadsheet programs include built-in functions like NPV, which help you determine discounted cash flows. You can also download free discounted cash flow templates to simplify the process even more.

• Free DCF calculators – many financial calculators are available online without charge. They provide a quick way to perform DCF calculations by guiding you through entering your cash flows and discount rate to quickly get the results you need.

Using these tools can help you focus on making the right financial decisions without getting bogged down by complex calculations. They're ideal for making bookkeeping for small businesses simpler, allowing you to manage your money more efficiently.

Practical applications of discounted cash flow

We’ve already touched on the versatility of the discounted cash flow model and how it can be used across various aspects of small business management, including:

• Business valuation

• Project and investment evaluation

• Financial planning

Let’s take a peek at these different areas in a bit more detail.

Business valuation

Knowing the real worth of your business is essential, especially if you’re thinking about expanding or selling up. Discounted cash flow is great for this because it helps you figure out the cash your business might make in the future.

DCF analysis is also handy if you’re setting up a limited company and thinking about bringing in investors to help get you off the ground a bit quicker. It provides a detailed financial projection that can attract and reassure potential backers.

Project and investment evaluation

Discounted cash flow analysis is useful when you’re looking at both specific projects and broader investment decisions within your business. It lets you check if big ideas and investments are likely to pay off.

Considering whether to introduce a new product range to your online store? DCF lets you see the cash you might rake in and helps you decide if the new line will bring in enough to cover costs like storage and marketing and still generate a profit.

Or, thinking about how to make extra money by reducing your small business expenses might lead you to consider automating how to do a payroll. DCF does the maths on the long-term savings versus the initial cost of investing in the necessary software, helping you figure out if the investment is sound.

In both cases, DCF lets you compare various options to ensure you’re investing in the small business ideas and projects that offer the best returns.

Financial planning

Using DCF in your financial planning can transform how you handle small business finances. It provides a snapshot of what future earnings might look like today, which is important for managing cash flow and maintaining a robust small business budget.

Accurate cash flow forecasts are a big help when it comes to deciding where and when to spend or save. DCF is effective whether you’re figuring out how to improve cash flow or planning small business crowdfunding campaigns, offering the insights you need to make good decisions.

Common mistakes in applying DCF

When you get into doing discounted cash flow analysis, it’s easy to run into a few common hiccups that can throw off your valuations or investment strategies. Here are some pitfalls to avoid.

Using the wrong discount rate

Selecting an inappropriate discount rate can skew DCF calculations. If the rate is too low, you risk underestimating the costs involved in things like kicking off business ideas from home, potentially leading you to overinvest in underperforming ideas.

On the flip side, a rate that’s too high might lead you to undervalue investments, causing you to pass on promising opportunities like low cost high profit business ideas or chances to cash in on hobbies that make money.

Knowing the ins and outs of your cash flow statement and operating cash flow can help you work out accurate discount cash flows, thereby evaluating risk and picking the appropriate discount rate.

If you’re finding this part tricky, consider revisiting our earlier tips on conducting risk assessments and consulting with experts before you make any big decisions. This can help with, say, pinpointing how to price a service or calculating the most effective way to make money from home.

Overestimating future cash flows

It’s common for entrepreneurs who are just starting out and learning how to run a business to have overly optimistic expectations about future earnings. This holds true whether you’re exploring how to start a business from home or considering opening a retail store on the high street.

To counter this and ensure more realistic forecasting, it’s vital to have a good grip on the basics of running a business, like how to do market research for small business and how to identify your target market.

Understanding how to perform a SWOT analysis for small business can also assist by highlighting your company’s strengths, weaknesses, opportunities, and threats. This helps make your financial forecasts more realistic by considering both your business’s internal situation and broader environment.

Ignoring market conditions and economic factors

Without a SWOT analysis, it’s easy to overlook things like market trends and the economic climate when doing DCF analysis, but they really matter. For example, inflation rates or economic downturns can change your costs and what you might earn, shifting your financial forecasts.

Knowing how to do a competitor analysis and using effective pricing strategies can also help you handle these unpredictable factors.

For instance, when you’re figuring out how much it costs to start a business or launch an online shop, these techniques help you adjust your plans and prices based on what your competitors are doing and the economic situation.

Simple marketing techniques like using QR codes to draw in customers or learning how to use social media for small business can also make a big difference in keeping customers engaged and buying, which is key for reliable forecasting.

Underestimating the importance of customer retention

Not paying enough attention to customer retention can cause your business to perform well below its potential. What’s more, a loyal customer base usually translates to stable and recurring cash flows, reducing forecast variability and bumping up the accuracy of discounted cash flow valuations.

To boost customer loyalty, you might think about introducing a rewards program, such as offering gift cards with a spend over a certain value.

Additionally, bringing in new tech like portable, contactless card machines or a sleek point of sale solution not only speeds up transactions but also ramps up customer satisfaction and contributes to efforts on how to create a positive working environment.

By keeping both customers and staff happy, such technological solutions can help keep your cash flow stable and improve your business’s reliability for DCF calculations.

Disclaimer: The contents of this page are intended for informational purposes only and should not be construed as professional advice. For matters requiring legal or financial expertise, it’s recommended to seek guidance from qualified professionals.