Three Mistakes to Avoid When Calculating a Discounted Cash Flow

I’ll admit that, particularly in the last few years, not many of my clients have used the discounted cash flow (DCF) method for determining whether or not an investment is worthwhile over the longer term. It’s not such a mystery why: The analysis relies on interest rates to determine the value of dollars invested today vs. what their worth would be a few years from now. In these days of historically low interest rates, the issue has been mostly moot.

But that’s changing. Due to a stronger economy and low unemployment, the Federal Reserve has been increasing interest rates, and it plans more hikes over the next year. As interest rates rise, so does the importance of the DCF method when trying to determine an investment’s return. My expectation is that more of my clients will be using this calculation  in the years to come, and I hope you will be, too. But be careful. It’s easy to make these three mistakes when calculating a DCF.

Mistake Number 1: Using the Wrong Interest Rate

You’re not a large investment bank that can negotiate preferred interest rates. You’re probably like me—a small business—and subject to typical market rates available from traditional banks. Some of my clients use interest rates that are too low or make the mistake of thinking that the federal funds rate (that is, the rate at which the Fed lends to banks) is the same rate they’ll be paying. It’s not—and making this mistake can have a tremendous impact on the results of your analysis.

As a rule of thumb, use the rate a local bank would charge its retail customers for a mortgage…and then bump it up a point. It’s conservative and—in these times of increasing rates—likely realistic.

Mistake Number 2: Assuming Too Aggressive a Payback Period

Sorry, but we’re not in Vegas. When you make an investment, you’re not going to get your money back right away and then treat your friends to breakfast at 4 a.m. Sure, some gambles—even in business—can pay for themselves almost immediately. But most of the transactions I’ve seen take years to return the amount invested, along with a profit. So be reasonable with your expectations. Usually, the larger the investment, the longer it takes to make back your money. A small piece of equipment may take just two to three years. A large machine can take as much as five to seven years. Property often takes longer.

A guideline (though not a hard rule) could be the depreciation period used for tax purposes for the investment you’re thinking of making, so check with your accountant. Like the interest rate you choose, be conservative and use a longer payback period.

Mistake Number 3: Being Too Optimistic About Your Future Cash Flows

I get it. We’re business owners. We tend to see the world through rose-colored glasses. But for the purposes of calculating a DCF, you need to have a different, tougher attitude. How realistic are your forecasted revenues from the investment? What other costs should you be projecting? Does this correlate to other similar examples? Are you sure you’re thinking of everything?

If your forecasted revenues for the investment are overly optimistic and not realistic, you could be setting yourself up for failure. If you make an investment based off of overly inflated numbers, your returns may be significantly less. So how can you tell if the estimates you’re using are good? Your best bet is to bounce your future cash flow estimate off of friends, advisors, and experts to get their opinions. They’ll be able to tell you if your projected cash flows seem high and may even offer a different amount to think about.

I know I’m repeating myself, but be conservative. Take a worst case position. Whatever future cash flow you’re projecting, project a little less and give yourself room for error. If you can’t earn a good return even in that case, then the investment may not be worth making—and that’s doing yourself a favor.

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You probably haven’t paid much attention to the discounted cash flow method over the past few years and I get it. When interest and inflation are so low, your future cash flows won’t be much changed. But interest rates are changing. So brush off your calculator—and try to avoid the mistakes I’ve mentioned.

As a small business owner, you’re an expert, too. We want to hear about how you feel about discounted cash flow. Let us—and your fellow SBOs—know by sharing a comment below.