Discounted Cash Flows

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Would you rather have a cookie today or a cookie a year from now? Almost everyone picks today. A cookie in your hand right now beats the promise of one much later. Money works the same way. If someone offered you 10 dollars today or 10 dollars a year from now, you would take it today, because you could use it right away, or tuck it in the bank and have a little more than 10 dollars by next year.

This leads to one of the most important ideas in the world of money: a dollar in the future is worth less than a dollar today. Discounted cash flow is a way of using that idea to figure out what money you expect to get later is really worth right now.

Why is future money worth less?

There are a few reasons a dollar later is worth less than a dollar now:

• You have to wait. While you wait, you cannot use or grow that money. If it were in the bank earning Interest, it would already be getting bigger.
• The future is uncertain. A promise of money later might not come true, but cash in your hand is sure.
• Prices tend to creep up over time, an effect called Inflation, so the same amount of money usually buys less in the future than it does today.

Shrinking future money down to today

To compare future money with today's money fairly, you "discount" it, which just means shrinking it down to what it is worth right now.

Here is a simple example. Suppose money in the bank grows by 10 in 100 each year, which is another way of saying 10 percent. If you put 100 dollars in today, next year you would have 110 dollars. Turn that around, and a promise of 110 dollars next year is worth about 100 dollars to you today. So we would "discount" that future 110 dollars back down to 100 dollars. Money that arrives even further in the future gets shrunk even more, because you have to wait even longer for it.

Adding up the cash flows

The "cash flows" are simply the payments you expect to receive over time, year after year. A project might pay you a little next year, more the year after, and so on. Discounted cash flow puts everything together in three steps:

1. Guess how much money you expect to get in each future year.
2. Shrink each of those future amounts down to what it is worth today, shrinking the later ones more.
3. Add all of those "today" values together. The total is what the whole future stream of money is worth right now.

Why it matters

This is how grown ups decide whether something is worth buying or building. Imagine a company thinking about opening a new factory, or a studio deciding whether to make a movie. They guess how much money it will bring in over many years, discount all of that back to today, and add it up. If the total is bigger than what it costs to build, the idea might be worth doing. If it is smaller, they may walk away. The whole method rests on an idea called the Time Value of Money, which is just the fancy name for "money now is worth more than money later."

Fun facts

• The word "discount" here has nothing to do with a sale or a coupon. It means shrinking a future amount down to its value today.
• People have known that money now beats money later for thousands of years, but the careful math for discounting cash flows only became common in business in the last hundred years or so.
• The number used to shrink the future money is called the "discount rate," and choosing it is a bit of an art. A small change in that rate can make the very same project look like a great deal or a terrible one.