Discounted Cash Flow Definition
Discounted cash flow (DCF) is a valuation method used to estimate the intrinsic value of an investment based on its expected future cash flows.
Discounted cash flow analysis is a powerful tool, but it is not without its limitations. The most important thing to remember is that DCF is a forward-looking model, which means it relies heavily on assumptions and estimates about the future.
That being said, DCF can still be a helpful tool for estimating the value of an investment. Let’s take a closer look at how it works.
When valuing an investment using DCF, we start by estimating its future cash flows. These cash flows can come from different sources, such as operating income, interest payments, or dividends. Once we have estimated the cash flows, we discount them back to present value using a discount rate.
The discount rate is typically the weighted average cost of capital (WACC), which reflects the riskiness of the investment. The higher the discount rate, the lower the present value of the cash flows will be.
Finally, we sum up all of the present-value cash flows to arrive at an estimate of intrinsic value.
Keep in mind that there are many different ways to estimate future cash flows, and there is no one ‘correct’ way to do it. As with any valuation method, DCF is only as good as the assumptions that go into it.
