Discounted Cash Flow - DCF

Discounted Cash Flow - DCF

A valuation method used to estimate the attractiveness of an investment opportunity. DCF analysis uses future free cash flow projections and discounts them to arrive at a present value, which is used to evaluate the potential for investment. Most often discounted by the weighted average cost of capital.

If the value arrived at through DCF analysis is lower then the current cost of the investment, the opportunity may be a good one.

Basic Formula:

Notes:

DCF models are powerful but they do 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 is taken in the valuation. A simple annuity is used to estimate the terminal value past 10 years for example. This is done because as time goes on, it is harder to come to a realistic estimate of the cash flows.

See also: Capital Budgeting, Cash Flow, Cost of Capital, Free Cash Flow, Intrinsic Value, Internal Rate of Return -IRR, Net Present Value - NPV, Payback Period