{"id":8802,"date":"2022-08-05T00:04:43","date_gmt":"2022-08-04T18:34:43","guid":{"rendered":"https:\/\/aayushbhaskar.com\/?p=8802"},"modified":"2023-03-08T14:30:41","modified_gmt":"2023-03-08T09:00:41","slug":"dcf-valuation","status":"publish","type":"post","link":"https:\/\/aayushbhaskar.com\/dcf-valuation\/","title":{"rendered":"DCF (Discounted Cash Flow) Valuation – Explained","gt_translate_keys":[{"key":"rendered","format":"text"}]},"content":{"rendered":"

So you have heard a lot of market jargon that will last you a lifetime.<\/p>\n

The bad news is that you will listen to more of it as new words, acronyms, and phrases are minted and make their way into financial literature.<\/p>\n

Some will make sense, and others not so much. However, and I can guarantee you this, once you hear the phrase \u201cDCF valuation model,\u201d you will be left in a sense of wonder and awe.<\/p>\n

What is it? What is it used for?<\/p>\n

How is it used for what it is used for?<\/p>\n

The positives? The negatives?<\/p>\n

Well, I am here to help.<\/p>\n

This post is for anyone who wants to understand DCF and not be left awestruck the next time they hear someone say this on TV or at a social gathering.<\/p>\n

Better yet, by the time I am done with this, I hope some of you will be confident enough to throw this phrase around and sound like a finance guru.<\/p>\n

Ready? Good. Let’s go.<\/p>\n

1. What is DCF?<\/b><\/h2>\n

DCF stands for discounted cash flow. This valuation technique is built on the sound theory that a $ of cash flow today is dearer than a $ of cash flow in the future.<\/p>\n

Go back to when you were a child and your uncle from out of town came visiting and offered you a choice because he didn’t bring the duty-free box of chocolate you crave.<\/p>\n

Take a $1 bill today or wait for him to visit the next time and get you two boxes of chocolate.<\/p>\n

You will weigh more than what you can get today than you may get in the future. So, your choice is to grab on to that $ bill.<\/p>\n

Your response here is guided by the certainty of the present and the uncertainty of the future. After all, no one knows when the uncle will visit again, and there is no guarantee that he will remember to bring one box of chocolate, let alone two, the next time he does come.<\/p>\n

Also, maybe I wouldn’t like chocolates the next time he comes because I am entering my teens and want to get busy building that Six Pack?<\/p>\n

Whatever the reason, we have a logical & rational framework to work with here. Cash flow today is dearer than cash flow in the future.<\/strong><\/p>\n

2. What Is The Discount in DCF?\u00a0<\/b><\/h2>\n

The beauty of finance is that there is no room for philosophy unless it can be mathematically articulated. The Lordships of Finance (early academics) debated on how to model discounted cash flow for years. The prevailing theory, after much deliberation, centered around the notion of opportunity cost.<\/p>\n

I have $ today that I can invest<\/a> and get $1.1 a year later. Whether this is a good deal would depend on what else I can do with the $ today.<\/p>\n

Say I can invest it elsewhere and get $1.2 a year later. Naturally, I will frame the first opportunity in the context of the second. In this case, the next best opportunity available has a higher potential rate of return and I will not invest in the first.<\/p>\n

To speak academically, the discount factor is the required rate of return from the investment being appraised. This could be the general market return, the risk-free rate, the risk-free rate plus some equity premium, or any other appropriate benchmark. It will vary based on the situation.<\/p>\n

3. What can DCF be used to value?\u00a0<\/b><\/h2>\n

DCF has many real-world applications in the sphere of valuation. These include but are not limited to:<\/p>\n