Discounted Cash Flow Method

A discounted cash flow is a valuation method used to estimate the future cash flow of an investment opportunity. This simply means that you are figuring out what future cash flows, or earnings, are worth today.

In order to find the present value, the future cash flow must be discounted to properly find the value of a future company or investment. The discount rate which is used reflects the time value of money and a risk premium. The risk premium is the extra return that investors expect in case the investment fails. The future cash flows method is used to evaluate the capability of an investment. If the future cash flow value that is found is greater than the current cost of the investment, then it is considered a good investment to make.

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The flaw which is found in the discounted cash flow method is that any little adjustment can produce big changes in the results. This can make a company seem like they have much more or much less value than they actually do. Also, it is very difficult to estimate future cash flows for a very long period of time. As time goes on, it is harder to estimate a realistic future cash flow value. So if a company is in need of estimating the future cash flow for more than ten years then a different approach is needed to be taken.

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