Discounted cash flow explained
Discounted cash flow (DCF) is a method of valuation that uses the future cash flows of an investment in order to estimate its value. You can calculate it as per Figure 2.
As the hypothetical CEO of WellProfit, you’d first calculate your discount rate and your NPV (which, remember, is the difference between the present value of cash inflows and the present value of cash outflows over a period of time and is represented above by “CF”).
Then you can perform a DCF analysis that estimates and discounts the value of all future cash flows by cost of capital to gain a picture of their present values. If this value proves to be higher than the cost of investing, then the investment possibility is viable. Let’s say you have an investor looking to invest in a 20% stake in your company; you're growing at 14.1% per year and produce $561,432 per year in free cash flow, giving your investor a cash return of $112,286 per year. How much is that 20% stake worth now?
The investor will assess the amount they’ll earn this year ($112,286), in year two ($112,286 x 1.141 = $128,118), and so on. We’ll change our discount rate from our previous NPV calculation. Let’s say now that the target compounded rate of return is 30% per year; we’ll use that 30% as our discount rate. Calculate the amount they earn by iterating through each year, factoring in growth.
You’ll find that, in this case, discounted cash flow goes down (from $86,373 in year one to $75,809 in year two, etc.) because your discount rate is higher than your current growth rate. Therefore, it’s unlikely that, at this growth rate and discount rate, an investor will look at this one as a bright investment prospect. Bad news for WellProfit.
To put it briefly, DCF is supposed to answer the question: "How much money would have to be invested currently, at a given rate of return, to yield the forecast cash flow at a given future date?" You can find out more about how DCF is calculated here and here.