If you are a young entrepreneur or a novice investor, we bet you would like to know which investment opportunities are the best. Or which ones are actually worth your money. However, as we all know, the market can be fickle. Still, what if we told you that there is a way in which one could estimate just how attractive an opportunity is in investing terms? A mathematical way? This is what discount cash flow valuation is. Read more below.
The Discounted Cash Flow Equation
As mentioned in the introduction, the discounted cash flow is a type of valuation method. It is typically used to estimate how good an investment opportunity really is. It will analyze the future free cash flow projections, and then it will discount them. The equation uses an annual rate so that it can reach the present value estimates. This is then used to show how much potential an investment has.
If the value you have come to through the DCF turned out to be higher than what your investment costs, then the opportunity you are faced with might turn out to be a good one.
Here’s how the equation looks like.
DCF = [CF1/(1+r)1] + [CF2/(1+r)2] + … + [CFn/(1+r)n]
CF = Cash Flow
r = discount rate (WACC)
As you can see, the calculations involved in this are wildly complex. However, the purpose of this analysis is to estimate the amount you, as an investor, stand to receive from the investment you are about to make. Then adjust it taking into account the time value money has.
The time value of money is the hypothesis that currency today is worth more than it will be tomorrow. Let’s look at an example of this for a better understanding.
Let’s say you have $1 in a savings account. The interest on it is five percent per year. This amount will be worth $1.05 in a year’s time. Considering that, we must also take into account symmetry. In other words, that, if a equals b, then b must also equal a. Therefore, if $1 is worth $1.05 in a year from now, then $1.05 from the future year is worth $1 now.
That’s what you need to use when you are trying to assess how valuable a future investment is. And when working with the discount cash flow valuation.
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What Are the Limitations of the DCF?
While these models are powerful, based on the mathematical principle behind them, you should know that they can only be as strong as the data you feed into them. Even the smallest change in the input can then lead to a significant change in how you estimate or value an investment.
As a conclusion, the discount cash flow valuation is and must be still regarded as a tool much more than anything else. Especially if you’re a beginner in the art of investing, you need to learn how to assess an opportunity for yourself and feed the correct data into the model.