Receiving $200 is strictly better than receiving $100. Receiving $100 now is strictly better than receiving $100 in a year. But it is not clear whether it is better to receive $90 now or $100 in a year.
Similarly, it is always better to receive $100 with absolute certainty than to receive $100 80 percent of the time. However, some would rather receive $79 with absolute certainty than $100 with 80 percent certainty.
This is a problem that must be solved in order to make perform discounted cash flows (or make simple investment decisions). A company’s value will vary not only with the magnitude of future cash flows, but when the cash flows occur and with what level of risk.
For valuation practitioners, both problems are usually solved through the discount rate or required rate of return. The discount rate is the rate of return for which an investor is indifferent between investing and not investing. For example, if one can achieve a 4 percent return without risk, then one would be indifferent between receiving $100 now and $104 a year from now since $100 could be invested at the risk free rate. If an investment is riskier, then investors will require a higher rate of return to set aside money.
Applying a discount rate to a future cash flow yields a present value via the following formula:
- PV is the present value. This is the current value of the future payment.
- NCF is the net cash flow. This is the amount of money the investor will receive after netting all expenses. Higher cash flow yields a higher value.
- d is the discount rate or required rate of return, as discussed above. If investors demand a higher rate of return, then they will pay less for a future cash flow.
- t is the time until the payment. Investors will pay less for payments further into the future.
According to the discounted cash flow methodology, the value of a company is equal to the present value of all future payments to investors.