Discounted Cash Flow
Summary of the DCF Method. Abstract
The DCF method calculates what someone is willing to pay today in order to receive the anticipated cash flow in future years. DCF means converting future earnings to today's money. The future cash flows must be discounted in order to express their present values in order to properly determine the value of a company or project under consideration as a whole.
The DCF for an investment is calculated by estimating the cash you will have to pay out and the cash you think you will receive back. The times that you expect to receive the payments must also be estimated. Each cash transaction must then be discounted by the opportunity cost of capital over the time between now and when you will pay or receive the cash.
For example, if
inflation is 6%, the value of your money would halve every ±12 years. If
you are expecting an asset to give you an income of $30.000 a year in 12
years time, that income stream would be worth $15.000 today if inflation
was 6% for the period. We have just
discounted the cash flow of $30.000: it's only worth $15.000 to you at this
History: DCF was first formally articulated in John Burr
Williams' 1938 text 'The Theory of Investment Value' after the market crash
of 1929 and before auditing and pubic accounting were mandated by the SEC.
As a result of the crash, investors were wary of relying on reported income,
or indeed, any measures of value besides cash. Throughout the 1980s and
1990s, the value of cash and physical assets became steadily less well
correlated with the total value of the company (as determined by the stock
market). By some estimates, tangible assets dropped to less than one-fifth
of corporate value (intangible
assets such as customer relationships, patents, proprietary business
models, channels, etc. comprising the remaining four-fifths).
Book: S. David Young, Stephen F. O'Byrne - EVA and Value-Based Management: A Practical Guide to Implementation
Book: Aswath Damodaran - Investment Valuation: Tools and Techniques for Determining the Value of Any Asset
Book: James R. Hitchner - Financial Valuation: Applications and Models
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