Discounted Cash Flow

Meaning of Discounted Cash Flow

The discounted cash flow is a quantification method used to evaluate the attractiveness of an investment opportunity. The Discounted Cash Flow analysis involves the use of future free cash flow protrusions and discounts them so as to reach the present value, which is then used to calculate the potential for investment. This is done by using the weighted average cost of capital. The opportunity is considered to be a good one if the value reached at through the discounted cash flow analysis is greater than the current cost of investment.

Calculation (formula)

The discounted cash flow is calculated as:

A discounted cash flow is considered as the most primarily accurate way of evaluating an investment. Many other methods of evaluation, like valuation ratios, can, to some extent, be considered as simplified estimates of a discounted cash flow. The various assumptions and estimates required by a discounted cash flow bring forward a lot of uncertainty, thus making it no better than simpler forms.

The free cash flows provide the firm with its investment value. The calculation of a present value helps in adjusting the future cash flows to replicate the fact that money planned to receive in future features lesser worth than what is being received at present.

The discounted cash flow analysis is, therefore, a balance of the amounts of cash which are being paid as well as received by the business during a specific time period. Many a times, these payments and receipts are tied to particular projects. But, sometimes, these cash flows and payments might also originate from particular companies. The value of a project or company is determined by these calculations.

During the valuation process of a business, the discounted cash flow, implicating the cash flow (inflow as well as outflow) generated by the business discounted by a rate equivalent to the risk to those prospective cash flows. Thus, the accretion of the future cash flows discounted by the risk minus debt indicates the value of a business.

To cap up, it would be right to describe the DCF valuation as a process of evaluating the investment-worthiness of a company’s stock.