How does discounted cash flow differ from the other valuation methods?
Discounted cash flow (DCF) is a valuation method that estimates the intrinsic value of an investment by calculating the present value of expected future cash flows. It differs from other valuation methods in several ways.
1. Focus on cash flows: DCF analysis focuses on the cash flows generated by an investment over its projected lifespan. Other methods, like the price-to-earnings (P/E) ratio or price-to-sales (P/S) ratio, use different metrics, such as earnings or revenue, to value the investment.
2. Time value of money: DCF considers the time value of money, which means that a dollar received in the future is worth less than a dollar received today due to inflation and the opportunity cost of capital. DCF accounts for this by applying a discount rate to future cash flows, whereas other methods may not consider the time value of money.
3. Future projections: DCF requires estimating future cash flows, which can be challenging due to uncertainty and the need for accurate forecasting. Other methods, such as comparable company analysis or asset-based valuation, may rely more on historical or present data rather than future projections.
4. Flexibility: DCF allows for flexibility in assumptions and scenarios. It enables analysts to incorporate various growth rates, discount rates, and other factors specific to the investment being evaluated. Other methods may be less flexible and rely on predetermined multiples or fixed criteria.
To compute the intrinsic value using DCF, one needs to follow these steps:
1. Estimate the future cash flows expected to be generated by the investment.
2. Determine an appropriate discount rate (usually the weighted average cost of capital) to reflect the risk and time value of money.
3. Calculate the present value of each expected cash flow by dividing it by the appropriate discount rate.
4. Sum up the present values of all expected cash flows to arrive at the discounted cash flow.
5. Compare the discounted cash flow to the current market price of the investment to make a buy/sell decision.
In summary, DCF differs from other valuation methods by its focus on cash flows, incorporation of the time value of money, reliance on future projections, and flexibility in assumptions.