What is DCF?
DCF stands for Discounted Cash Flow and it is a measurement or valuation of money to reflect if an investment is good or attractive. It is the amount of money a person is willing to invest at present to get a pre-computed cash flow at some time in the future. In literal terms, it converts supposed money in the future to its value in the present. It is termed “discounted” to express the correct value of a company or an investment in present times.
There are various other methods to value an investment like using valuation ratios, but DCF or discounted cash flow is said to be the most correct. DCF involves cash estimation of one’s investment today and the expected return in the future. In terms of asset, its value today is related to the supposed returns it may bring tomorrow. In an investment, the cash flows are adjusted according to the risks and time value of money. These cash flows may be in the form of returns of capital, dividends, interest payments, and repayments.
When it comes to risk, the discount rate will be higher if the risk is also higher. This discount rate is essential in forecasting cash flows in the future to have a correct valuation of money in the present time. Time value of money meanwhile refers to estimates and projections on the value of money over time. The main idea is that money is said to have more value today than in the future. This is mainly because first, there is risk involved. Money’s certain value in the present may not be as certain at some time in the future. There is also the inflation factor, which lowers the value and buying power of money in the future.
DCF valuation is quite a complicated task. Many financial analysts need to dig deep into records and details to have a correct valuation of money or an investment. It is said that after DCF analysis, when the resulting value is higher than the present investment cost, the said investment is considered a good opportunity.