Discounted Cash flow valuation analysis model
What is Discounted Cash flow (DCF)
Discounting cash flow Model is a valuation method used to estimate the value of an investment based on its future cash flows. DCF analysis finds the present value of expected future value cash flows using a discount rate. A present value estimate is then used to evaluate a potential investment. If the value calculated through DCF is higher than the current cost of investment.
Discounting of cash flow is calculated as follow:
DCF = Cf1/(1+ r)1 + Cf2/(1+ r)2 + Cf3/(I + r)3 …………Cfn/(I + r)n CF here stands for cash flow.DCF is also represented as cash flow model
Purpose of discounted cash flow (DCF)
The purpose of discounted cash flow analysis is to estimate the money an investor would receive from an investment, adjusted for the time values of money. The time value of money assumes that a dollar today is worth more than a dollar tomorrow. A challenge with the DCF model is choosing the cash flows that will be discounted when the investment is large, complex or the investors cannot access the future cash flow.
The valuation of a private firm would be largely based on cash flows that will be available to the new owners.DCF analysis also requires a discount rate that accounts for the time value of money (risk-free rate) plus a return on the risk they are taking. Its depend on the purpose of purchase of an investment.
Limitations of Discounted cash flow model
A discounted cash flow model is powerful but there are limitations when applied too broadly or with bad assumptions. Such as the risk-free rate changes over time and may change over the course of a project. Applying DCF Models to complicated projects or investments that the investor cannot control is also difficult or nearly impossible.