Discounted Cash Flow (DCF) valuation method was originally developed to evaluate cash flow of companies. However, it can also be used effectively to evaluate the discounted growth rate of your investments when compared with some established benchmark. The selected benchmark, preferably, is a relatively low risk instrument with a guaranteed annual yield, such as a savings bank account. The idea is to measure your earnings by ignoring that part of your profit, which could have been earned from investing in the low-risk, low-gain benchmark over the same period. The earnings value that you arrive at by using this calculation is your discounted earning.
The need for a discount-value exploration of personal portfolio arises from the fact that many long-term investors overlook the 'time value' aspect of their investments when evaluating the growth of their portfolio. Time value of capital is the basic appreciation expected in its value from investing it over a period of time. In simple terms, £1000 deposited to your kitty today has more value than the same amount handed to you a year later. This is because when invested at a rate of 10% today, £1000 will yield £100 in a years time. Or, in other words, today's value of £1000, handed to you one year from now, is £910.
A major economic force that drives time value and affects your savings/investment is 'inflation.' The impact of inflation, which can be observed in daily life, degrades the buying power of your capital over time. As a result of which you are forced to spend more money every year to maintain your regular lifestyle. Consequently, you must give some consideration to inflation when planning for your future requirements. You need to invest in such a way that your savings do not lose their value over time and also continue to grow.
Let us examine a case to better understand this valuation process and to learn to make use of the DCF calculator. Say, your investment of £10000 from a year ago has recently paid a return of £3000, a good 30% growth. However, during the same period, your bank's savings account paid out interest at the rate of 5%. This, in effect, means that your original investment amount could have earned you £500 if you had left it parked in your bank account for the same period. Here, the basic 'time value' of your investment is £500. To arrive at a discounted value of your portfolio, this amount must be ignored from the total earnings.
