Simply Putting Discounted Cash flow Analysis

Whenever an investment decision is made, its pros and cons are always evaluated by the investor. Or in financial jargon you can replace pros and cons with risk and return associated to the investment. It could be any kind of investment such as investment in start-up businesses or acquiring some stocks of existing company but the main emphasis is on how much money is going to be made from this investment decision. The mostly used valuation technique is Discounted Cash Flow (DCF) method through which one arrives at the future cash flows expected from the investment. This valuation model’s main function is to adjust the future earnings with the time value of money which decreases year over year due to inflation. Discounted cash flow method use a discount rate to adjust projected cash flows for next five or ten years to calculate a Net present value of return on investment. Net present value (NPV) is derived by subtracting adjusted future cash inflows from future cash outflows.  The method could be used for analyzing any kind of investment.

One can ask the reasoning for discounting or adjusting the future cash flows. We will not go into the economical details but in a simpler way it could be said that the value of one dollar decreases over time that what if one dollar can buy two sweets today then next year most probably that one dollar could buy only 1 sweet. This is called time value of money. So let’s suppose if your investment yields $10000 today and $10000 in next two years then that $10000 earned today is greater than $10000 earned in next two years. So the earnings of next year need to be adjusted or discounted to get the present value of money. This is why discounted cash flow method is used as an investment analysis tool. However this asset valuation method like others also has some limitations but it is most widely used as one can only speculate or estimate the returns but could not derive accurate or actual value.