Discounted Cash Flow (DCF)
Candlefocus EditorIn order to properly utilize DCF analysis, the investor must be able to accurately estimate its future cash flows. This is often done by looking back at the recent performance of the investment and making projections based on current market conditions. These projections are based on a variety of factors, including the overall state of the economy, the industry the investment resides in, and the strength of the company’s management. Generally, the more certain the estimated cash flows are, the more reliable the DCF valuation will be.
The investor must also select an appropriate discount rate, which should reflect the return the investor requires to make the investment worthwhile. Many investors use the weighted average cost of capital (WACC) for the discount rate due to its accuracy in reflecting the risks associated with their investment. WACC is the average of all debt and equity costs, weighted by their respective proportions in the capital structure of the company.
Once the estimated cash flows, discount rate, and duration of the investment are determined, they are then discounted to the present to calculate its net present value (NPV), or today’s worth. The NPV is then compared to the purchase price to assess the potential returns of the investment. If the NPV is lower than the purchase price, the investment may not be profitable, and vice versa.
One of the main drawbacks of discounted cash flow analysis is that it relies heavily on the estimations of future cash flows, which are not always accurate. As such, there is always some degree of uncertainty in this type of valuation. Nonetheless, when executed properly, DCF is arguably one of the most reliable methods of valuing an investment.