What Does Discounted Cash Flow (DCF) Mean?
A valuation method used to estimate the attractiveness of an investment opportunity. DCF analysis uses future free cash flow projections and discounts them (most often by using the weighted average cost of capital method) to arrive at a present value, which is used to evaluate the investment's potential. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one. It is calculated as follows:
Investopedia explains Discounted Cash Flow (DCF)
There are many variations in what can be used for cash flows and the discount rate in a DCF analysis. Despite the complexity of the calculations involved, the purpose of DCF analysis is simply to estimate the money one would receive from an investment, adjusting for the time value of money. DCF models are valuable tools, but they have shortcomings. DCF is merely a mechanical valuation tool, which makes it subject to the axiom “garbage in, garbage out.” Small changes in inputs can result in large changes in the value of a company. Instead of trying to project the cash flows to infinity, a terminal value approach often is used. A simple annuity is used to estimate the terminal value past 10 years, for example. This is done because it is harder to come to a realistic estimate of the cash flows as time goes on.
Related Terms:
• Cash Flow
• Cash Flow Statement
• Free Cash Flow—FCF
• Internal Rate of Return—IRR
• Net Present Value—NPV
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