By Aniket Bose. Edited by Arjun Chandrasekar
Overview
Discounted cash flow (DCF) is a valuation method used to estimate the value of an investment based upon its cash flows in the future. DCF analysts attempt to figure out the value of an investment in the current time, making their predictions based on projections of how much that investment will create in the future. If the DCF is above the current cost of the investment, then it means that it could result in a profit for the investor. The DCF has limitations, mainly in that it heavily depends on future cash flows of that investment, which could prove to be completely inaccurate.
How does Discounted Cash Flow Work?
The purpose of DCF analysts is to estimate the amount of money that an investor would obtain from an investment, adjusted for the value of money over time. The value of money over time estimates that a dollar today could be worth a lot more than a dollar tomorrow because it can be invested and earn interest over time.
Any situation where a person is paying money in the present having expectations of obtaining more money in the future is appropriate for a DCF analysis. For instance, suppose your friend has a 5% annual interest rate on their investment, $1 in a savings account will be worth $1.05 after one year. Likewise, if a $1 payment is delayed by your friend for a year, then the investment’s current value would be 95 cents since they did not transfer it to their savings account for earning interest.
In DCF analysis, the main job is to find the current amount of anticipated projected cash flows through the means of a discount rate. Investors can use the concept of the present value of money for determining whether the projected cash flows of investment are greater than or equal to the principal amount of the original investment. If the value calculated through DCF is higher than the present costs of the investment, then it is a good time for the investor to sell the investment to make a profit.
To conduct a DCF analysis, an investor must estimate projected cash flows and the ending value of the investment or any asset. The investor also has to determine a proper discount rate for the DCF model, which varies depending on the investment, such as the investor’s risk profile and the conditions of capital markets. If the investor is unable to access the projected cash flow amounts, then the DCF will not have a lot of value and the investor should start to consider using other alternative models.
Conclusion
DCF analysis is a particular valuation method used to estimate the value of an investment based on its projected cash flows. It essentially sets a rate of return (RoR) or a discount rate just by looking at dividends, earnings, and free cash flow which is used to place a value on a business, without other market conditions. Since there are so many unknown factors with DCF, it’s very easy to acknowledge why most investors decide to use multiple valuation models to inform their decision-making regarding their investment!
