Understanding discounted cash flow
Learn the basics of DCF and how it can help you optimize your business. Presented by Chase for Business.
Knowing the value of your business is an important part of achieving your business goals. The earlier you begin tracking your business’s value, the easier it is to make informed decisions for a winning business strategy. Plus, this information can be useful if you ever decide to seek funding from an investor to expand your operations.
When it comes to figuring out the value of your business, many methods are at your disposal. One of the most common — and the way that Harvard Business School refers to as the gold standard for business valuation — is discounted cash flow. Here’s what you need to know about this valuation process, including steps for how to calculate it for your own business.
What is discounted cash flow valuation?
Discounted cash flow, often abbreviated as DCF, can help you learn how to value a small business by calculating the current value of business by considering its expected earnings.
What sets DCF apart is its ability to adjust these earnings based on the concept of the “time value of money.” Simply put, it recognizes that a dollar in your pocket today is worth more than the same dollar in the future. This is due to many factors, including rising inflation.
By factoring in this crucial element, discounted cash flow aims to provide a more accurate picture of the future value of your business in today’s terms. Think of it like a financial time machine that helps you determine the present worth of the money your business is expected to earn down the road.
But DCF isn’t just for business valuation purposes. You can also put this calculation to work when deciding whether a business investment — like upgrading your equipment — will ultimately pay off over time. It’s a versatile tool that can help guide many of your financial decisions.
Understanding the discount rate
To calculate your business’s discounted cash flow, you’ll first need to decide a few things. One decision is the discount rate you’ll apply to your business’s future cash flow.
Here’s where things can get a bit tricky. This rate takes into account the level of risk associated with your business. So determining which discount rate to use largely hinges on your business’s funding situation. In general, a higher discount rate represents a higher risk, and lower rates represent lower risk.
As a good starting point, consider using the federal funds rate as your discount rate. This sets your business’s required rate of return on par with the growth rate typically seen in savings accounts. It’s a conservative approach that can serve as a baseline. As you learn more about your business over time, you can adjust this rate to better reflect your business realities and return on investments.
Once you’ve settled on your discount rate, it’s time to calculate your business’s cash flow. This involves subtracting your business expenses from your net income. Not a whiz at math? Small business resources like the Business Cash Flow Tool can help you capture an accurate picture.
How to calculate discounted cash flow
With that information, you can now calculate discounted cash flow. Take the sum of your business’s cash flow and divide it by one plus the discount rate. The formula appears as follows
This formula can then be used to calculate multiple years by adding them together:
As mentioned earlier, this formula can not only help you learn how to value a small business — it can also help you determine if a business investment will pay off over time. Simply plug into the equation the cash flow that you expect the investment will generate, and you’ll learn the present value of that investment’s future cash flow. With this knowledge in your arsenal, you’ll be better equipped to make more informed decisions about your business and how to invest in its growth.
Advantages and disadvantages of DCF
Before you begin using this equation to evaluate your business, it’s important to understand its insights and limitations.
One of the biggest benefits of discounted cash flow analysis — and one of the reasons it’s a highly regarded form of business valuation — is that it’s rooted in reality. DCF zeroes in on your company’s ability to generate liquid assets by focusing on its current cash flow. In this way, it sidesteps the unpredictable ebbs and flows of the market, making it a more objective way to determine your business’s true value.
Another benefit is how easy it is to calculate. You can easily do it on your own, or with a little help, in an Excel spreadsheet.
Because the process for calculating DCF is extremely detailed, it also can help you track the financial health of your business. The calculation uses specific and important assumptions about your business that you should pay attention to. Crunching these numbers for your business will help you see how certain adjustments can affect your business in the long term.
One of the disadvantages of using the discounted cash flow valuation model is that it relies on several estimates and assumptions. If you overestimate your cash flow, you may miss your targets or make a poor investment decision. Underestimating isn’t good either, because it may mean you are missing out on a growth opportunity for your business.
Keep in mind that, despite your best effort to predict outcomes, all investments come with a certain amount of risk. Using the discounted cash flow model is just one of many ways to value your business, assess investment decisions and take stock of the health of your operations.
Take steps to optimize your business
Want to learn more ways you can evaluate and advance your business? Speak with a Chase business banker to explore business resource services and the ways Chase can help you achieve your business goals.