Briefly – What is Discounted Cash Flow Analysis?
Discounted Cash Flow (DCF) analysis is a method used to estimate the value of an investment based on its expected future cash flows. The principle behind DCF is that money today is worth more than the same amount in the future due to the time value of money. To perform a DCF, you do the following:
- Forecast future cash flows: Estimate the cash inflows the investment is expected to generate over a set period.
- Determine a discount rate: This rate reflects the risk of the investment and the time value of money.
- So what is the discount rate? The core concept behind a discount rate is that money available today is worth more than the same amount in the future due to its potential earning capacity (interest or investment growth). This is typically related to the yield on “Risk free Assets” widely accepted as being treasury bonds. Many other factors may weigh into an investor’s opinion about what the discount rate should be, such as inflation expectations, public policy, economic situations, the tax environment, etc.
- Discount the future cash flows: Apply the determined discount rate to future cash flows to calculate their value.
- Combine the present values: Add up the present values of all future cash flows to determine the total value of the investment. This is one method of analysis. It is complex and time consuming because of the assumptions involved, but it can be a valuable tool in determining a good investment opportunity.
The information in this post was compiled by S. Zachary Fineberg, CFP(r) Managing Member of Fineberg Wealth Management, LLC, a registered investment advisor. If you would like to schedule a consultation to discuss how Fineberg Wealth Management can help you reach your long-term financial goals, please make contact to discuss.
