Discounted cash flow

Discounted cash flow is simply a method of working out how much a share is fundamentally worth based on the present or discounted value of expected future cash flows.

Money receivable in the future is worth less than money received immediately. If you have £1 now and could invest it at an interest rate of 5% in one year you would have £1.05. This means that the 'future value' of £1 in one year is £1.05.

Put it the other way around and the 'present value' of £1 received in one year is £0.952. This is because £0.952 is the amount that would grow to £1, if invested at 5%. The interest rate assumed is known as the discount rate.

This is the concept behind most investment. You pay a lump sum for the right to receive a sum or a series of sums at some point in the future. To know how much you should pay for that right you need to work out its present value.

Discounted cash flow is simply a method of working out how much a share is fundamentally worth based on the present or discounted value of expected future cash flows. This is obviously fraught with difficulty given the nature of forecasting but the simplest version of the calculation is the dividend discount model where the real value of a share is considered to be the present value of the sum of all its future dividends.

See Tim Bennett's video tutorial: Five ways companies can cook cash flow.

Most Popular

Shareholder capitalism: why we must return power to listed companies’ ultimate owners
Investment strategy

Shareholder capitalism: why we must return power to listed companies’ ultimate owners

Under our system of shareholder capitalism it's not fund managers, it‘s the individual investors – the company's ultimate owners – who should be telli…
24 Jan 2022
Three innovative Asian stocks to buy now
Share tips

Three innovative Asian stocks to buy now

Professional investor Fay Ren of the Cerno Pacific Fund highlights three of her favourite Asian stocks to buy now
24 Jan 2022
Ask for a pay rise – everyone else is
Inflation

Ask for a pay rise – everyone else is

As inflation bites and the labour market remains tight, many of the nation's employees are asking for a pay rise. Merryn Somerset Webb explains why yo…
17 Jan 2022