The general method of discounting cash flows to estimate an asset’s value is commonly referred to as DCF. In the following, we will elaborate on both how the DCF works and what the net present value (NPV) has to do with it. There will also be an example that should nail down the difference between the two terms.
What’s the DCF?
The DCF is a financial model and can be viewed as the primary tool in valuation that is used to estimate the intrinsic value of any asset that generates cash flows. The key proposition within the DCF is that the value of an asset is the present value of its future cash flows:
The formula above shows that according to the DCF, any asset’s value is equal to the sum of all cash flows (CF) in each period t divided by 1 + the discount rate (r) to the corresponding period t.
DCF stands for discounted cash flow and explains exactly what analysts, companies, and investors do when they create a DCF: discounting cash flows at a specific discount rate to get the present value of those cash flows.
There are three key ingredients that are needed for a DCF:
- An estimation of the asset’s remaining life
- An estimation of the cash flows that the asset will generate during its life
- A discount rate to convert the future cash flows into a present value
The end goal is to determine the value of an investment which then can be used to decide whether the investment or project should be made or not.
The two primary components within a DCF are the cash flows and the discount rate. All there is in valuation is (1) to forecast cash flows (the amount of cash that you would theoretically get from your investment throughout the future), and (2) to come up with a respective discount rate (the percentage rate at which you want to discount the future cash flows).
Analysts and advanced investors usually spend a lot of time and effort on both components of the DCF because they require making reasonable assessments of a company’s risk profile and often vague estimates about its future.
The net present value (NPV) is the present value of all future cash flows within the DCF adjusted by the initial investment that had to be made in the first place. In other words, NPV is the difference between the initial investment costs and the present value of the asset:
The result of computing the NPV can either be positive or negative: The initial investment costs to fund a given project/investment can either be lower or higher than its present value. Any NPV that is positive (>0) shows that there is excess value that can be made from the investment/project. This is why companies often use the NPV metric to determine whether a project is worth the investment or not.
The Difference Between DCF and NPV
The DCF or discounted cash flow is a model/tool in which an asset is valued by discounting the cash flows it produces during its remaining life while NPV is a metric that can be utilized to assess the total rentability of the present value relative to the initial investment cost.
DCF and NPV can’t really be compared with each other because NPV is a metric that can be used in addition to the DCF.
In summary, the present value of all future cash flows and the initial investment cost are needed in order to calculate NPV and you get the present value by estimating those future cash flows and discounting them back into the present with a risk-adjusted discount rate (which is the DCF).
Example: Jane's Flowers
Let’s suppose that a local business called Jane’s Flowers wants to decide whether it should invest in a project, in which they expand their product line into the dried flower business. For simplicity, let’s further assume that Jane’s Flowers expects that the project will generate $1000 in cash flows each year for the next 10 years. By using a cost of capital of 10%, we could discount the cash flows respectively to arrive at the total present value:
As a result of our DCF, the total project would be worth $6,144.57 today.
Let’s further assume that the project costs an upfront investment of $8,000 to be carried out. $8,000 is obviously more than $6,144.57 which means that the project isn’t really worth the investment. The NPV, in this scenario, would be -$1855,43:
Therefore, according to our estimates, expanding the product line to include dried flowers would be a poor choice because it would actually lose us money (NPV is < 0).
The DCF is the general approach of estimating the value for any investment based on its remaining lifespan, the magnitude of cash-flows it produces, and the risk around generating those cash flows. NPV, on the other hand, is a metric that can be computed in order to quickly determine whether a given project is worth the investment or not.
The process of discounting cash flows and calculating the net present value can come in very handy in many financial decisions which is why it is commonly used in corporate decisions, financial analysis, and investment valuations.