How does discounted cash flow analysis work?

Discounted cash flow (DCF) analysis works by estimating the present value of future cash flows a company is expected to generate.

DCF analysis is a method used to evaluate the attractiveness of an investment opportunity. It uses future free cash flow projections and discounts them, using a required annual rate, to arrive at present value estimates. This present value estimate is then used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one.

The process begins with an estimation of future cash flows. This can be done by examining the company's past performance, industry trends, and other economic factors. These cash flows are then discounted back to their present value using a discount rate, which is often the weighted average cost of capital (WACC). The WACC takes into account both the cost of equity and the cost of debt, providing a comprehensive view of the cost of funding.

The sum of all these present values then gives the DCF analysis its final figure, known as the 'Net Present Value' (NPV). The NPV represents the projected value of an investment adjusted for risk and time. If the NPV is positive, it means that the projected earnings (in today's money) are more than the cost of the investment, indicating that the investment is potentially profitable.

However, it's important to remember that DCF analysis is only as accurate as its assumptions. If the estimates for future cash flows or the discount rate are off, the DCF analysis may not be reliable. Therefore, it's crucial to use conservative estimates and consider a range of scenarios when conducting a DCF analysis.