Huh? That's the reaction of most people when they first hear of it. But the concept is simple and commonly used by professional investors to value shares.

So how does it work? Let's say some lunatic offers you a choice: $10,000 now or $10,000 in five years' time. Unless you're as loony as he is, you'd choose to have the money now. But if the choice was between $10,000 now and $15,000 in five years, chances are that you'd at least consider taking the money later.

The reason behind this is twofold. If you're an investor, money now is money that you have available for investment. If you took that $10,000 and invested it, you should have much more than $10,000 in five years' time. If you're a spender, there's also a strong bias towards having the money now. You can buy what you want at today's price, rather than waiting and paying more in the future after inflation has pushed the price up.

When you make the choices we've just outlined, you're weighing up the value of the money you'll get today with the value you'll get in the future.

But what has that got to do with shares?

Rob Prugue, a director of van Eyk Research, says discounted cash flow models (and their cousins, dividend discount models) simply try to value shares on the basis of their future income in today's dollars. He says the discounted cash flow model uses the "free cash flow" of the company generally taken as earnings before interest, tax, depreciation and amortisation while the dividend discount model simply takes the amount paid out as dividends. The disadvantage of the dividend discount model is that companies can alter dividends, whereas cash flow better reflects the company's earnings. Companies that retain part of their earnings for reinvestment, for example, should increase their overall value and thus their share price.

Prugue says the simplest discounted cash flow model is expressed algebraically as:

Price = income per share (over) required rate of return - growth in income.

So, for example, if your company is currently earning 10¢ per share, your required rate of return is 3 per cent above the 10-year bond rate (currently 5.25 per cent, giving you a required rate of return from the shares of 8.25 per cent), and you're expecting the cash flow to grow by 3 per cent a year after inflation, the notional price you'll pay for the shares is $1.90. There are more sophisticated discount models that allow you, for example, to look at staged growth for the dividends, but the principle doesn't change much.

Do brokers' reports show these numbers?

Prugue says you'll often find the discounted cash flow expressed as an internal rate of return (IRR). This is a similar calculation; but it calculates the rate of return implicit in the current share price, rather than you setting the return you want. A high IRR is obviously good, but Prugue says you need to look at the risk involved. Often a high IRR simply means a company is extremely volatile.

How important are these calculations when the market values shares?

They're widely used and understanding them can give you some insights into what professional investors are thinking and where companies should be valued. But Prugue says you should never take them as gospel. The problem is that the results can vary dramatically, depending on your assumptions, and no-one really knows how a company's income will grow or what's likely to happen to interest rates and inflation. A fall in interest rates, for example, would reduce your desired rate of return and you'd have to redo the figures. Similarly, if a company's earnings prospects took a dive, the discounted cash-flow model would need to take this into account.

"Any discounting model is extremely vulnerable to the `GIGO' principle it's a case of garbage in, garbage out," Prugue says. "These models are powerful but susceptible to inaccuracies. You have to second-guess them constantly because things are constantly changing."

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