What is Discounted Cash Flow (DCF)?

What is Discounted Cash Flow (DCF)?

Discounted Cash Flow (DCF) is a financial valuation method used to estimate the value of an investment based on its expected future cash flows. The central idea behind DCF is that the value of an investment today is the present value of all its future cash flows, discounted back to the present using an appropriate discount rate. DCF analysis is widely used in finance and investment decision-making, including valuing stocks, bonds, real estate, and business projects. It provides a rigorous and theoretically sound framework for assessing the attractiveness of investment opportunities by considering both the timing and riskiness of future cash flows....

How does Discounted Cash Flow work?

Discounted Cash Flow (DCF) works by estimating the present value of an investment’s expected future cash flows. The process involves several steps,...

DCF Formula

The general formula for DCF is,...

FCFF in DCF

FCFF represents the cash flows generated by a company’s operations that are available to all providers of capital, including both equity and debt holders. It is calculated as the cash flow from operations minus capital expenditures, plus or minus changes in working capital, minus taxes. FCFF is a measure of the company’s ability to generate cash flow from its core business operations after accounting for necessary capital investments and taxes. It is often used in discounted cash flow (DCF) analysis to determine the intrinsic value of a company’s equity....

FCFE in DCF

FCFE represents the cash flows generated by a company’s operations that are available to its equity shareholders after accounting for necessary capital expenditures and debt repayments. It is calculated as the cash flow from operations minus capital expenditures, plus or minus changes in working capital, minus debt repayments, plus net borrowing. FCFE measures the cash flow available to equity investors for distribution as dividends, share buybacks, or reinvestment in the business. FCFE is often used in equity valuation models to estimate the value of a company’s equity by discounting its expected future FCFE....

Advantages of DCF

1. Intrinsic Valuation: DCF provides an intrinsic valuation of an investment by estimating its present value based on expected future cash flows. This approach focuses on the fundamental value of the investment, rather than relying solely on market prices or comparable transactions....

Disadvantages of DCF

1. Sensitivity to Assumptions: DCF analysis relies heavily on assumptions, including cash flow projections, discount rates, and terminal values. Small changes in these assumptions can lead to significant variations in the calculated present value, potentially resulting in unreliable valuation estimates....

Discounted Cash Flow – FAQs

What discount rate should I use in DCF?...