The Discounted Cash Flow Method is a method to value a project by taking all future projected cash flows of the project and discounting them back to time zero (date of purchase) using a predetermined discount rate (the discount rate when used in a DCF to look at an investment can be looked at as synonymous to an investor’s targeted IRR). The value that is deduced from doing this is what an owner/investor would be willing to pay today in order to receive the projected cash flows from the project in the future and take on the risk.
An investor is looking at an office building to purchase and hold for five years. The investor will use all his own cash to buy the project and after underwriting he believes the project will produce the following cash flows:
This investor knows he can put this same money in a slightly less risky investment at 7% and so in order to consider this opportunity over the other, he values the incremental risk at a 1% premium and thus, requires that the cash flow above results in an 8% return. In other words, he is looking to achieve an 8% IRR on this cash flow. The investor now needs to resolve what he would pay today in order to earn 8% on the money invested.
To solve this formulaically for annual periods, we need to apply this formula to the cash flow above:
Inputting our assumptions gives us the following:
Simply adding this all up provides us with a purchase price of $4,723,211. So, if our investor were to consider this deal, he would need to be able to close on this property at $4,723,211 or less.
Solving with Excel
Implementing a Discounted Cash Flow Analysis using Excel is actually quite simple with the =NPV() formula. Click the mouse into a blank cell and type
Once you do that, the formula guide will ask for a rate. Type
after you type the comma, take the mouse and highlight all the cells that have the cash flows in it and press Enter. This should return the present value of the cash flows discounted at the required rate. If this is not fully clear to you, please watch the video below for further explanation of the DCF Method.