Discounted cash flow
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In the field of finance, a discounted cash flow is the value of an investment (measured in terms of the cash you will put into and receive from it) adjusted for the time value of money. The future cash flows must be discounted in order to express their present values in order to properly determine the value of a company or project under consideration as a whole.
The discounted cash flow for an investment is calculated by estimating the cash you will have to pay out and the cash you think you will receive back. The times that you expect to receive the payments must also be estimated. Each cash transaction must then be discounted by the opportunity cost of capital over the time between now and when you will pay or receive the cash.
Math
In mathematical terms, discounted cash flow is the product of:
- the anticipated nominal magnitude and sign of a cash flow, and
- the accumulated discount over the amount of the amount of time remaining until the anticipated time of the cash flow, at a discount rate equivalent to the opportunity cost of capital.
History
Promoted informally after the market crash of 1929, discounted cash flow was first formally articulated in John Burr Williams' 1938 text 'The Theory of Investment Value' at a time before auditing and public accounting were mandated by the SEC. As a result of the crash, investors were wary of relying on reported income, or indeed, any measures of value besides cash.
Throughout the 1980s and 1990s, the value of cash and physical assets became steadily less well correlated with the total value of the company (as determined by the stock market). By some estimates, tangible assets dropped to less than one-fifth of corporate value (knowledge assets such as customer relationships, patents, proprietary business models, channels, etc. comprising the remaining four-fifths).