Discounted cash flow
The term ‘discounted cash flow’ (DCF) refers to a technique for valuing a business in terms of its likely cash yields in the future. It is a form of analysis frequently used when purchasing a business. The analysis values the business based on the value of all cash available to investors in the future. It is described as ‘discounted’ since the value of cash in the future is worth less than cash today (because of its reduced capacity for generating a return, such as interest, and because of inflation).
 Calculating discounted cash flow
There are three elements in calculating discounted cash flow:
- The period of time used for the evaluation.
- An accurate estimation of the annual flows of cash that will occur during that time.
- The amount of money that could be earned if it was invested in something else of equivalent risk.
Very broadly, assessing the annual cash flow which is to be discounted involves:
- Using the net income after tax, add on depreciation for the year.
- Subtract the change in working capital from the previous year.
- Subtract the capital expenditures.
Whilst discounted cash flow is a useful tool, it does have drawbacks. In particular, small changes in input values can result in large changes in the value of the company. An accurate valuation using discounted cash flow relies on the owner’s ability to project future cash flow accurately, which can prove difficult. It is also is more suited to long-term investment than short-term investment, and investors should consider other valuations as well as discounted cash flow before making a decision.
However, with recent accounting scandals and inappropriate revenue calculations, discounted cash flow has increased in popularity since it gives investors a more transparent measure for gauging performance and it provides a good picture of the key drivers of share value. It is also a method that is not as likely to be manipulated by aggressive accounting practices and it provides an accurate stock value to investors.
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