Discounted Cash Flow (DCF)

Considering working with venture capitalists or angel investors to provide funding and fuel your business growth plans?

Then, you’ll want to be on top of a little-known financial metric called discounted cash flow.

While you won’t find discounted cash flow on any of your typical financial statements, it’s an important measurement that many angels and VCs use to understand the future value of a potential investment.

In this guide, we’re going to dive deep into discount cash flow. We’ll cover how to calculate it, improve it, and make it enticing to investors.

What Is Discounted Cash Flow?

Discounted cash flow is a valuation method designed to estimate the future value of cash earned.

It’s used by potential investors to determine the value of an investment opportunity today, based on the anticipated future cash flow of the company being invested in.

Essentially, then, discount cash flow (often abbreviated as DCF) is a decision-making tool. It helps VCs and angels decide whether a company is worth investing in.

Of course, it’s not just for investors.

Business owners and leaders can use DCF as a decision-making tool when engaging in capital budgeting or deciding how to allocate operating expenditures. However, this will always be in light of potential funding opportunities, whether present or future.

How Does Discounted Cash Flow Work?

Compared to most other financial metrics, DCF is a little tough to get your head around.

Before we dive into figures and formulas, let’s discuss some of the financial theory behind the idea of discounted cash flow.

DCF rests on the assumption that a dollar in the hand today is worth more than a dollar in the hand tomorrow because today, you can invest that dollar.

Let’s imagine you have $1,000 in your account. If you earn an interest rate of 5% per annum, the future value of that cash (in a year) is $1,050.

But let’s say you’re anticipating a payment of $1,000 a year from now. That cash is only worth $9,950 at present because you can’t invest it like you could if you had it on hand now.

Investors use this logic to discount the value of future cash flow.

The cash that your company will throw off in a year (or two, or five) is worth less than it would be today, because they don’t have the ability to earn on that future cash flow.

Potential investors will compare the present value of future cash to the investment they’re considering.

If the calculated value falls below the cost of investment, then it’s probably not a good investment. On the other hand, if the present value of future cash—or discounted cash flow—still surpasses the cash investment required today, then it may be a good opportunity.

Discounted Cash Flow Formula + Example

The formula for discounted cash flow is not the simplest, unfortunately.

Stick with us. Here it is:

DCF = ((CF1/(1+r)1) + ((CF2/(1+r)2) + ((CFn/(1+r)n) 

Where:

• CF1 = cash flow for year one
• CF2 = cash flow for year two
• CFn = cash flow for subsequent years
• r = your chosen discount rate

So, to calculate discounted cash flow, you need two things:

• A discount rate
• Estimated cash flow for each year

Let’s imagine that an investor is calculating DCF on a three-year investment horizon using the following figures:

• CF1 = $1m
• CF2 = $2m
• CF3 = $3m
• r = 5%

Plugging those figures into our DCF formula, then:

DCF = (($1m/(1+5%)1) + (($2m/(1+5%)2) + (($3m/(1+5%)3) 

Which becomes:

DCF = ($952,380) + ($1,814,058) + ($2,591,512) = $5,357,950

Note, here, that while the total expected cash flow equaled $6m, our discounted cash flow comes in at $5,357,950.

When To Use Discounted Cash Flow

Discounted cash flow is almost exclusively used by angels and VCs to determine whether an investment is a good opportunity.

The need to use DCF to assess this increases when the expected investment horizon is longer (i.e., the investors anticipate seeing returns several years in the future).

Other factors that might increase the need to use this metric include high rates of inflation—where future money is worth significantly less—and when bank interest rates are unusually high, as the opportunity cost of the investment is higher.

However, DCF is not an investor-only metric.

Some business owners and financial leaders may choose to calculate, and seek to improve, discount cash flow if they’re gearing up for a funding round.

Knowing that investors are likely to use this figure to assess a potential investment, a business owner might pre-calculate DCF and share this figure during funding conversations.

What Are The Pros and Cons of Discounted Cash Flow

Discounted cash flow is far from a perfect metric. Here’s what’s good and bad about it.

Pros of Using Discounted Cash Flow

DCF can provide potential investors like angels and VCs with a better idea of whether a potential funding opportunity is worthwhile.

It helps them stack up various opportunities with different investment horizons so they can understand the opportunity cost of cash in one place vs. another.

Cons of Using Discounted Cash Flow

The big drawback of discounted cash flow is that it’s heavily reliant on assumptions.

Of course, nobody can predict cash flow with perfect accuracy. This becomes even trickier with earlier-stage companies that don’t have a long track record of revenue or might not even be throwing off cash yet.

The longer the time horizon you’re using, the less valid this calculation becomes (e.g., DCF works better if you’re looking at two years out vs. eight years out).

This presents a challenge for using DCF as an objective measure. If estimated cash flows are too high, then the investment might not pay off. If the estimates are too low, investors might pass up good opportunities.

Then, you’ve got all the external factors to consider, such as:

• The economy as a whole
• Market and industry-specific trends
• Inflation and interest rates
• Technological changes
• Unforeseen competitor entrants

These factors impact the discount rate you choose to use, which can have varying degrees of accuracy.

For all of these reasons, DCF is a great measurement to put a “today” investment in the context of a “tomorrow” payout, but it should always be used as only part of a formal investment analysis and paired with other common valuation methods.

Calculate Discounted Cash Flow In Finmark

Looking to calculate and even track discounted cash flow yourself, so you can present a solid set of figures to potential investors?

The most ambitious small business owners use Finmark from BILL to calculate DCF using a custom formula.

Plus, by using Finmark to calculate important metrics like burn rate and runway, and to create upside and downside budgets, you can deliver a comprehensive set of financial projections to improve your likelihood of securing a funding opportunity.

Dive in and find out for yourself just what Finmark can do. Start your 30-day free trial here.