Discounted Cash Flow (DCF) is a powerful analytical method for looking at the performance of an investment. Here is an excerpt from Wikipedia that shows an example of how the analysis is performed. I am learning how to apply a calculation method like this to our cash flow properties.
John Doe buys a house for $100,000. Three years later, he expects to be able to sell this house for $150,000.
Simple subtraction suggests that the value of his profit on such a transaction would be $150,000 - $100,000 = $50,000, or 50%. If that $50,000 is amortized over the three years, his implied annual return (known as the internal rate of return) would be about 13.6%. Looking at those figures, he might be justified in thinking that the purchase looked like a good idea.
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 John Doe buys the house, the 3-year US Treasury Bill rate is 5%. Treasury Bills are generally considered to be inherently less risky than real estate, since the value of the Bill is guaranteed by the US Government and there is a liquid market for the purchase and sale of T-Bills.
So, calculating exclusively for opportunity cost, we get a discount rate of 5% per year. Using the DCF formula above, that means that the net present value of $150,000 received in three years is actually $129,146 (rounded off). Those future dollars aren't worth the same as the dollars we have now.
Using simple subtraction again, the present-value profit on the sale would then be $29,146 or a little more than 29%. Amortized over the three years, that implies a discounted annual return of 8.6% (still very respectable, but only 63% of the profit he previously thought he would have). Note that the original internal rate of return (13.6%) minus the discount rate (5%) equals the discounted internal rate of return (8.6%). The discount rate directly modifies the annual rate of return.
But what about risk?
The house John is buying is in a "good neighborhood", but market values have been rising quite a lot lately and the real estate market analysts in the media are talking about a slow-down and higher interest rates. There is a probability that John might not be able to get the full $150,000 he is expecting in three years due to a slowing of price appreciation, or that loss of liquidity in the real estate market might make it very hard for him to sell at all.
For the sake of the example, let's then estimate his risk factor is about 5% (we could perform a more precise probablistic analysis of the risk, but that is beyond the scope of this article). Therefore, this analysis should now include both opportunity cost (5%) and risk (5%), for a total discount rate of 10% per year.
Going back to the DCF formula, $150,000 received three years from now and discounted at a rate of 10% is only worth $111,261 (rounded off) in present-day dollars. The present-value profit on the sale is now down to $11,261 discounted dollars from $50,000 nominal dollars. The implied annual rate of return on that discounted profit is now 3.6% per year.
That return rate may seem low, but it is still positive after all of our discounting, suggesting that the investment decision is probably a good one: it produces enough profit to compensate for opportunity cost and risk with a little extra left over. When investors and managers perform DCF analysis, the important thing is that the net present value of the decision after discounting all future cash flows at least be positive (more than zero). If it is negative, that means that the investment decision would actually lose money even it appear to generate a nominal profit. For instance, if the expected sale price of John Doe's house in the example above was not $150,000 in three years, but $130,000 in three years or $150,000 in five years, then buying the house would actually cause John to lose money in present-value terms (about $6,000 in the first case, and about $9,000 in the second). Similarly, if the house was located in an undesirable neighborhood and the Federal Reserve Bank was about to raise interest rates by five percentage points, then the risk factor would be a lot higher than 5%: it might not be possible for him to make a profit in discounted terms even if he could sell the house for $200,000 in three years.
In this example, only one future cash flow was considered. For a decision which generates multiple cash flows in multiple time periods, DCF analysis must be performed on each cash flow in each period and summed into a single net present value.
Wikipedia contributors (2006). Discounted cash flow. Wikipedia, The Free Encyclopedia. Retrieved 23:35, April 22, 2006 from http://en.wikipedia.org/w/index.php?title=Discounted_cash_flow&oldid=49480149
John Doe buys a house for $100,000. Three years later, he expects to be able to sell this house for $150,000.
Simple subtraction suggests that the value of his profit on such a transaction would be $150,000 - $100,000 = $50,000, or 50%. If that $50,000 is amortized over the three years, his implied annual return (known as the internal rate of return) would be about 13.6%. Looking at those figures, he might be justified in thinking that the purchase looked like a good idea.
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 John Doe buys the house, the 3-year US Treasury Bill rate is 5%. Treasury Bills are generally considered to be inherently less risky than real estate, since the value of the Bill is guaranteed by the US Government and there is a liquid market for the purchase and sale of T-Bills.
So, calculating exclusively for opportunity cost, we get a discount rate of 5% per year. Using the DCF formula above, that means that the net present value of $150,000 received in three years is actually $129,146 (rounded off). Those future dollars aren't worth the same as the dollars we have now.
Using simple subtraction again, the present-value profit on the sale would then be $29,146 or a little more than 29%. Amortized over the three years, that implies a discounted annual return of 8.6% (still very respectable, but only 63% of the profit he previously thought he would have). Note that the original internal rate of return (13.6%) minus the discount rate (5%) equals the discounted internal rate of return (8.6%). The discount rate directly modifies the annual rate of return.
But what about risk?
The house John is buying is in a "good neighborhood", but market values have been rising quite a lot lately and the real estate market analysts in the media are talking about a slow-down and higher interest rates. There is a probability that John might not be able to get the full $150,000 he is expecting in three years due to a slowing of price appreciation, or that loss of liquidity in the real estate market might make it very hard for him to sell at all.
For the sake of the example, let's then estimate his risk factor is about 5% (we could perform a more precise probablistic analysis of the risk, but that is beyond the scope of this article). Therefore, this analysis should now include both opportunity cost (5%) and risk (5%), for a total discount rate of 10% per year.
Going back to the DCF formula, $150,000 received three years from now and discounted at a rate of 10% is only worth $111,261 (rounded off) in present-day dollars. The present-value profit on the sale is now down to $11,261 discounted dollars from $50,000 nominal dollars. The implied annual rate of return on that discounted profit is now 3.6% per year.
That return rate may seem low, but it is still positive after all of our discounting, suggesting that the investment decision is probably a good one: it produces enough profit to compensate for opportunity cost and risk with a little extra left over. When investors and managers perform DCF analysis, the important thing is that the net present value of the decision after discounting all future cash flows at least be positive (more than zero). If it is negative, that means that the investment decision would actually lose money even it appear to generate a nominal profit. For instance, if the expected sale price of John Doe's house in the example above was not $150,000 in three years, but $130,000 in three years or $150,000 in five years, then buying the house would actually cause John to lose money in present-value terms (about $6,000 in the first case, and about $9,000 in the second). Similarly, if the house was located in an undesirable neighborhood and the Federal Reserve Bank was about to raise interest rates by five percentage points, then the risk factor would be a lot higher than 5%: it might not be possible for him to make a profit in discounted terms even if he could sell the house for $200,000 in three years.
In this example, only one future cash flow was considered. For a decision which generates multiple cash flows in multiple time periods, DCF analysis must be performed on each cash flow in each period and summed into a single net present value.
Wikipedia contributors (2006). Discounted cash flow. Wikipedia, The Free Encyclopedia. Retrieved 23:35, April 22, 2006 from http://en.wikipedia.org/w/index.php?title=Discounted_cash_flow&oldid=49480149
posted by Walter at 4:43 PM
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