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Discounted Cash Flow – DCF

Attractiveness of an investment opportunity is estimated by this valuation method.Opportunity is regarded as good if analysis of DCF is greater than investment’s current cost. By using forecast period, which is determined, future’s cash flow can be set. Many people prefer to have money sooner than later so cash flows in different period cannot be compared directly. The time period during which cash flows are given to DCF formula is referred to as forecast period. DCF can be evaluated as:[ad#ad-4]

DCF = (CF1/(1+R)1) + (CF2/(1+R)2) + … +(CFN/(1+R)N)

Where CF = Cash Flow

R = Discount rate

Procedure of DCF involves three problems:

Future forecast cash flows

Taxes incorporation

Appropriate cost of capital needs to be determined.

It uses the concept of time value of money to value a company, asset or a project. Total  of incoming and outgoing future cash flows i.e. Net present value(NPV) is taken into account as the value of cash flows. By analyzing discounted cash flow analysis evaluation of net present value can be done.

In simple words we can say that DCF is a method in which someone can pay today so that he can get anticipated cash flow in future. At an interest rate future cash flows are discounted.

Two things can be reflected by discount rate:

  • Money’s time value: investors don’t have to wait and will receive cash value immediately.
  • Risk premium: it reflects the investor’s demand for extra return. Risk of cash flow not materializing at all can be compensated by this extra return.

Its models are dynamic in nature. But these models do have some disadvantages.DCF is regarded as a mechanical valuation tool. This means that it follows garbage in and garbage out method. Small amount changes made in inputs can lead to large changes in company’s value. Terminal value techniques are mainly used rather than projecting the cash flows to infinity. To estimate the terminal value simple annuity is used. This is because a realistic estimate of cash flows is harder to predict as time moves on.

Written by: Matt

We also suggest this relevant article if you have time: Portfolio Analysis

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