Question

What is the DCF method and why might we use this?

Answer 1

Discounted cash flow method or DCF method is one of the primary and important methods used in valuation. The premise of the model is around the fact that the value of the company today is the present value of future cash flows. Thus, discounting of future free cash flow is done using required return of capital to get present value of firm today.

If the discounted value is more than cost required to buy then the underlying asset may be undervalued and considered a good buy. If however, the projections of future cash flow are inaccurate then the value obtained using this method may be incorrect.

DCF value = CF1/(1+r) + CF2/(1+r)^2 +... CFn/(1+r)^n

Where CF1,2..n are cash floes in year 1,2..n respectively. And r is discount rate.

DCF is widely used as it gves fundamental value of the underlying. It relies on free cash flows and gives an overview of the intrinsic value of the underlying. It gives a single figure that helps management to decide whether to undertake the project or invest in the project. It makes comparison between projects easier.