# DCF – Discounted Cash Flow Valuation

Discounted Cash Flow (DCF) Valuation is a widely used financial valuation method that helps determine the intrinsic value of an investment, business, or asset. It is based on the principle that the current value of an investment is the sum of all its future cash flows, discounted back to their present value. The central concept behind DCF is that a dollar received in the future is worth less than a dollar received today due to the time value of money. Here's how the DCF valuation process works:
• Estimate Future Cash Flows: The first step in DCF valuation is to forecast the future cash flows that the investment or business is expected to generate over a specific period. These cash flows typically include operating income, capital expenditures, working capital changes, and any other relevant cash inflows or outflows.
• Select an Appropriate Discount Rate: The discount rate, often referred to as the "cost of capital" or "required rate of return," reflects the risk associated with the investment. It considers factors such as the company's risk profile, market conditions, and the overall economy. The discount rate represents the minimum return an investor would expect to earn from the investment to justify taking on its risk.
• Discount Future Cash Flows: Each projected cash flow is then discounted back to its present value using the chosen discount rate. The discounting process reduces the value of future cash flows to their equivalent value in today's dollars.
• Calculate Terminal Value: In many cases, the forecast period for cash flows is limited (e.g., 5 or 10 years). To capture the value beyond this period, a terminal value is calculated. This terminal value represents the value of the investment at the end of the forecast period and is typically based on a multiple of the last year's cash flow.
• Sum the Present Values: The present values of all forecasted cash flows and the terminal value are then summed together to arrive at the total present value, representing the estimated intrinsic value of the investment.
• Assess Sensitivity and Risks: Sensitivity analysis may be performed to understand how changes in assumptions, such as cash flow projections or discount rates, can impact the valuation. Additionally, risks and uncertainties associated with the investment are considered to evaluate its viability further.
• Compare to Market Price: Finally, the calculated intrinsic value obtained through the DCF valuation is compared to the current market price of the investment or asset. If the calculated value is higher than the market price, the investment may be considered undervalued, while a lower value may indicate that it is overvalued.
DCF Valuation is widely used by investors, analysts, and businesses to assess the attractiveness of an investment, determine a fair value for a company during acquisitions, and make informed financial decisions based on projected cash flows and their time value. However, it's essential to note that DCF valuations heavily depend on the accuracy of cash flow projections and the reliability of the chosen discount rate, and as such, they are subject to potential uncertainties and risks.

Prepared by: Seda Janazyan, Business Analyst at CFOnline.co

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