Discounted cash flow method
Discounted cash flow is a method of valuing a project, company, or asset using the concepts of the time value of money. It is an approach to valuation that is useful in determining how attractive a particular investment opportunity is likely to be for a given investor. Discounted cash flow is what one is willing to pay in order to receive the anticipated cash flow in the future years.
Discounted cash flow (DCF) considers the future free cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value, which is used to evaluate the potential for investment. It is also known as discounted cash flows model. If the value ascertained through the DCF analysis is higher than the current cost of the investment, the opportunity may be a good one. There are a lot of complexities involved in the calculation of discounted cash flow method; still the purpose of DCF analysis is just to estimate the money that the investor would receive from an investment and to adjust for the time value of money.
Discounted cash flow model is a powerful method but it does have disadvantages. DCF is merely a mechanical valuation tool, which makes it subjected to the "garbage in, garbage out". The project the cash flows is calculated to infinity; instead the terminal value techniques are often used. A simple annuity method is used to estimate the terminal value past 10 years, for example. This method is adopted as it is harder to come to a realistic estimate of the cash flows as time goes on. The calculation of the discounted cash flow can help investors and avoid committing to investments that are less likely to help them achieve their goals, and identify investments that demonstrate a high level of potential to aid them in reaching the desired results.