This is a valuation method used to estimate the attractiveness of an investment opportunity. Discounted cash flow analysis (DCFA) is an evaluation of the future net cash flows generated by a capital project by discounting them to their present-day value. It uses future free cash flow projections and discounts them to arrive at a present value in order to evaluate the potential for investment using most often the weighted average cost of capital. If the value arrived at through DCFA is higher than the current cost of the investment, the opportunity may be a good one. DCF converts future earnings into today’s money.
DCF is used for capital budgeting or investment decisions: To determine which investments projects a firm should accept; to determine the total amount of capital expenditure; and how a portfolio of projects should be financed.
The discounted cash flow can be calculated by projecting all future cash flows and making a calculated assumption on what the current value of that future cash flow is according to the image presented by our Einstein.
A relevant cost is an expected future cost that will differ from alternatives. The DCF method is an approach to valuation, whereby projected future cash flows are discounted at an interest rate reflects the perceived risk of the cash flows. The interest rate is reflecting by the time value of money (investors could have invested in other opportunities) and a risk premium.
The discount rate can be determined based on the risk-free rate plus a risk premium. Based on the economic principle that money loses value over time (time value of money), meaning that every investor would prefer to receive their money today rather than tomorrow, a small premium is incorporated in the discount rate to give investors a small compensation for receiving their money in the future rather than now. This premium is the so –called risk-free rate.
A small compensation called risk premium is incorporated against the risk that future cash flows may not eventually materialize, and that the investors will therefore not receive their money at all. Together determine the discount rate. With this discount rate, the future cash flow can be discounted to the present value. Our Einstein prepared a simple example calculation for you.
Pay attention, it is important:
DCF models are powerful, but they do have their faults. Models are so good as the information that was included in them. 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. The discount rate is especially difficult to calculate. Future cash flows are also hard to forecast, especially if the largest part of the future cash inflows is received after five or ten years.