What is Discounted Cash Flow?
Discounted cash flow (DCF) is a valuation method used to estimate the value of an investment based on its expected future cash flows, discounted to present value.
Example of Discounted Cash Flow
An investor estimates that a project will generate $100,000 annually for 5 years. Using a discount rate of 10%, the present value of these cash flows is calculated to determine the project’s worth.
How To Calculate Discounted Cash Flow
- Estimate future cash flows.
- Select a discount rate.
- Discount the future cash flows to present value.
- Special Tip: Choose a discount rate that reflects the riskiness of the cash flows and the opportunity cost of capital.
- Advantages
- Provides a comprehensive valuation based on expected performance.
- Consider the time value of money.
- Disadvantages
- Relies on accurate estimation of future cash flows and discount rates.
- Can be complex and time-consuming.
FAQs
What is a good discount rate to use?
It depends on the investment’s risk and the investor’s required rate of return.
Can DCF be used for all types of investments?
Yes, it is versatile and can be applied to various investments.
What are the limitations of DCF?
It is sensitive to input assumptions and estimates.
How does DCF compare to other valuation methods?
It is more detailed and considers the time value of money, but it can be more complex.
