Discount Factor

  

If you’re dabbling in financial modeling for funzies, you’ll definitely need to know about the discount factor. The discount factor is a number you can use to multiply your cash value by in order to get the present value.

Think about it this way: you might be projecting the cash flow of your future dominatrix lemonade company (the market wants what it wants), but you realize that money in five years won’t be able to buy what it can today. Today, lemonade might cost $3, but in five years, the inflation rate might cause lemonade to cost $3.50. That means the nominal amount of $3 can buy you more today than it will buy you in the future. Like...if you went back in time, you’d be rich.

Using the discount factor, you can bring money “from the future” into today’s dollars in terms of value. The discount factor takes out the effect of inflation so that you can calculate the present value of your cash flow.

Related or Semi-related Video

Finance: What is Discounted Cash Flow?9 Views

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Finance allah shmoop What is discounted Cash flow money air

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gets your money on sale discounted money Yeah kind of

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sort of like that but how can cash be discounted

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and what is flowing anyway Is this like a scene

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from huck finn goes to wall street so the cash

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we're talking about here is cash in the future Got

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it Your company the spice in ator ink sells a

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product that takes any item of food and runs it

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through a processor which makes it pumpkin spice flavor You

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are hated by starbucks everywhere So spice in aitor is

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going to make ten grand by the end of this

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year Fifty grand by the end of next year and

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for five hundred grand by the end of the following

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year and a million bucks by the end of the

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next All right that's not revenues that's profit Or at

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least so you you think it's going to earn a

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million bucks you estimate you guess you hope All right

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Well the value of a company in professional wall street

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he circles is the sum of the parts of its

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future cash flows or cash profits than discounted back for

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risk Meaning it might not actually earn that million dollars

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in four years and time What if those forty years

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or ten years or two years Alright all this means

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that spice in ator ink earning half a million bucks

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in three years is an estimated number It's not certain

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it's hope for begged for prayed for even at least

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in the red states but there is risk It doesn't

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happen Maybe there's thirty percent on that produces three hundred

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grand in profits instead of five hundred grand but ten

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percent odds It produces a million dollars instead of that

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five hundred grand and years out So calculating that risk

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and then discounting it in the value of the company

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Today is a big part of valuing a business parts

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that's the risk side But then there's the time side

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you have to think about as well If you had

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a company you were certain would make half a million

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dollars in profit thirty years from now you know like

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shmoop well that wouldn't be as impressive or valuable as

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a company You were equally certain would make half a

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million dollars in profit next year So that's the time

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component let's add up the notional value of this company

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just as an illustration here Alright Your company's spice in

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ater at the moment has no cash your debt and

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is for illustrative purposes on lee So don't get all

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technical on us and wine about details Try to glean

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a concept here okay So spicy nature will make ten

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thousand Dollars this year in profits it's january now in

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twelve months were eighty percent certain it'll make ten grand

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in profit All right now if we bought the safest

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bond in the world a one year u s treasury

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bond we get three percent interest We fight a discount

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on a thousand bucks Okay that number's serves as kind

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of a bassline whenever we do these kind of analyses

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the u s treasury paper is in generally riskless question

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how much riskier is our company Above and beyond the

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t bill I even company makes that ten thousand dollars

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like could it only make five thousand sure couldn't make

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nothing couldn't lose money Sure couldn't make way more than

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ten grand maybe twenty thirty forty grand Regardless there is

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risk here So the value of that ten thousand dollars

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a year from now carries what is called a risk

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premium tacked onto that three percent figure We're gonna divide

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by it So adding risk premium makes the present value

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less All right let's say that extra risk is pretty

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high like twelve percent That company produces meaningfully less than

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ten grand and profits All right well we discount back

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that One year from now figure of ten thousand dollars

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to be less right Well here's the math you take

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the amount expected to be earned Yes that is the

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cash flow ding ding ding and you divide by one

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plus the quantity of the risk free rate that t

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bill three percent thing plus the risk premium which we've

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guest is in twelve percent So what is the risk

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adjusted and discounted cash flow of ten thousand dollars expected

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or estimated a year from now worth today Well it's

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ten grand divided by the quantity one plus point zero

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three plus point one teo or divided by one point

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one five to the first power for this one year

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away and it looks like that which equals a bit

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under eighty seven hundred bucks So wow Interesting It means

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that the risk of getting that ten grand a year

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from now is high In fact it is worth roughly

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thirteen hundred bucks less today Because of that risk or

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set another way our analysis would suggest that you'd be

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risk neutral if you took a cashier's cheque today for

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eighty seven hundred bucks versus waiting a year and getting

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that Ten grand pay then But if you did wait

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well you'd have a very nice fifteen percent ish return

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on your invested money All right Welcome to risk people

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This is investing Wanna one's order and no extra charge

04:48

from the kindly loving people it's mum inside All right

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And as you'd guess you can get to the total

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value of the company by adding up and then discounting

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future years cash flows of this company in the same

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way when we have the ten grand number already What

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about the fifty k two years from now Well since

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we are comp pounding investment returns we make a call

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too Exponents land with e ticket there all day passed

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And to discount the odds of that fifty k coming

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to us two years from now we apply a similar

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calculation on lee Now we think that the odds of

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fifty k in two years are even riskier than they

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were before Will attach a seventeen percent risk premium toe

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actually getting out fifty grand a profit out of our

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product And we have to discount it back on top

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of the safe or risk free rate of three percent

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Well how's that work well we have fifty thousand bucks

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coming to us We think and hope and pray two

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years from now We then divided by one plus point

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zero three plus the risk premium of point one seven

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squared or to the second power Why Because it's two

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years of compounding away not one Remember I kind of

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mumbled that one year to the first power thing was

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clever on Alright that's Fifty grand over the quantity One

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point two square or fifty grand over one point four

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four or carrying a present discounted value of fifty k

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divided by that one point four four which is a

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little under thirty five grand Well if we carry this

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forward a year and there's even more risk for the

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fur five hundred thousand bucks we expect in three years

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Well then we get something like a risk premium of

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say twenty two percent tacked onto the safe rate of

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three percent or twenty five percent total And we discounted

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back three years or cubed if it looks like this

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Five hundred thousand dollars divided by the quantity one plus

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point oh three plus point two two to the third

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power Or that's five hundred thousand dollars over one point

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two five cubes Which is almost to telling us that

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the present value of that highly suspect five hundred k

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in profits supposedly coming in from spice in ator was

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about five hundred thousand over too or just over two

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hundred fifty grand in present value today Got it Well

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same holds true for that million dollar year and calculate

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the discounted cash value of that million bucks four years

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from now you follow the same pattern and add in

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the million bucks divided by the quantity one Plus you

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know all the other crap in there Yeah So if

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we're getting the total discounted cash flow valuation of the

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company we just add everything up including a sale of

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the company at the end Like if we sold it

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for two and million dollars six years from now we

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discount that back with some you know premiums and someone

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loaded in so that ten million's not a sure thing

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at all We have to assume our guests or dark

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board with blindfolds on the value of the company overall

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will hold for five years from now And yeah that's

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How This kind of cash flow works at least the

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one point overs you're learning here So just be careful

07:52

when you throw that dart You don't want to force

07:54

your business partners to rock and ipad shit no matter 00:07:57.755 --> [endTime] how much that looked cool Oh

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