Discounted Cash Flow (DCF) Analysis - A Tool for Investment
Earning Opportunities: Knowing Present Values
Insurance agent Mrs. Rollo was called by her agency manager to assist in computing insurance packages, which they are going to present the following week to some probable clients. She was amused because just the other night, a real estate agent also asked for her assistance. She has been in this business for two decades and has been able to earn more than one million dollars in sales commissions since she started.
Discounted Cash Flow: What Are the Commonly Used DCF Methods?
In finance, discounted cash flow (DCF) analysis is a method of valuing a project, company, or asset using the concepts of the time value of money.
There are two popular kinds of discounted cash flow:
1. The present value method is used in computing the current values of future values. This is commonly used in computing how much will be invested to received a certain amount of money in the future. Insurance packages are good examples of this kind.
2. Net present value is the present value of all future cash flows less the amount of initial cash investment required to purchase the investment property.
Examples and Computations of Present Value and Net Present Value
Example of a Present Value Method Application:
Let us take a simple example of a present value used in insurance packages:
Assume that you will receive insurance proceeds of $1,000 in 2 years. The interest rate is 7%. The question to be asked is: What is really the value of $1,000 after 2 years?
The formula will be: Present Value = Future Value divided by (1 + I)2
Given: Future Value = $1,000
Constant value = 1
Interest rate = 7%
Substituting them to the formula:
Present Value = $1,000 divided by (1+.07)2
Present Value = $873.44
Explanation: The value of $1,000 is not $1,000 after 2 years but only $873.44. The passage of time is considered in money valuation.
Question: Based on the above case, what is the importance of knowing how much is the present value ($873.44) of the amount you are going to receive after two years ($1,000)?
Answer: Assuming all variables constant, it is important to know how much is the valuation of such a future value ($1,000) after the specified time (2 years at an interest rate of 7%), because in comparing it with other insurance offers, for practical purposes, you will choose an investment which gives bigger present values.
Example of a Net Present Value Method:
To show how a discounted cash flow works in a real estate investment, consider Mr. Sotto who buys a house for $100,000. He expects to sell this house for $150,000 three years later. The question will be: Is it a profitable investment?
If you try to look at the given data, your simple calculation will run this way: $150,000 - $100,000 = $50,000. Mr. Sotto will probably obtain a profit of $50,000 from his investment three years later. If that $50,000 is amortized over the three years, his implied annual return (known as the internal rate of return) would be about 14.5%. Looking at those figures, he might be justified in thinking that the purchase looks like a good idea because 14.5% is quite bigger than the industry trend of 10%, for example.
1.1453 x 100,000 = 150,000 approximately.
However, since three years have passed between the purchase and the sale, any cash flow from the sale must be discounted accordingly. At the time Mr. Sotto buys the house, another 3-year short-term investment giving 5% interest and considered to be safer than real estate is offered. If Mr. Sotto hadn’t put his money into buying the house, he could have put it in the 3-year 5% relatively safe short-term investment. This 5% per annum can therefore be regarded as the risk-free interest rate for the relevant period (3 years).
The formula will be: Present Value = Future Value divided by (1.+ 1)3
The given data are the following:
Future Value - $150,000
Interest rate - 5%
Period – 3 years
Substituting the formula:
Present Value = $150,000 divided by (1 + .05)3
Present Value = $129,576 (rounded off)
It means that the value of $150,000 received in three years actually has a present value of $129,576 (rounded off). In other words we would need to invest $129,576 in the 3-year 5% investment to get $150,000 in an almost risk-free interest. This is a quantitative way of showing that money in the future is not as valuable as money in the present. ($150,000 in 3 years isn’t worth the same as $150,000 now; it is worth $129,576 now).
Subtracting the purchase price (or called original investment) of the house ($100,000) from the present value ($129,576) results in the net present value of the whole transaction, which would be $29,576 or a little more than 29% of the purchase price.
To summarize the above situation:
The expected future value or amount to be received by Mr. Sotto after three years is $150,000, but since we are going to consider the time value of money, such $150,000 will not be $150,000 after three years in terms of valuation. The real value of $150,000 after three years is $129,576, which is still bigger than what he invested ($100,000).
Therefore, the investment is still profitable at the amount of a positive net present value of $129,576 - $100,000, or $29,576.
When to use Discounted Cash Flow (DCF) Analysis
As a summary. when are we going to use DCF appropriately?
1. Consider the other factors that affect business, such as economy, philosophy of the management, time periods, and other factors that significantly affect the business.
2. Consider your inflows and outflows, which change over time. We must consider liquidity and solvency also.
3. Do not stick to one case. Use two or more alternative cases and compare because they differ with respect to cash-flow timing with the analysis period.