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LogoutDCF analysis is an intrinsic valuation method used to estimate the value of an investment based on its forecasted cash flows. It establishes a rate of return or discount rate by looking at dividends, earnings, operating cash flow or free cash flow that is then used to establish the value of the business outside of other market considerations.
In other words: It looks to answer the question, “How much money will I get from this investment over a period of time and how does that compare to the amount I could make from other investments?”
It does this by adjusting for the time value of money—which assumes a dollar invested today is worth more than a dollar invested tomorrow because it’s generating interest over that period of time.
To conduct a DCF analysis, assumptions must be made about a variety of factors, including a company’s forecasted sales growth and profit margins (its cash flow) as well as the rate of interest on the initial investment in the business, the cost of capital and potential risks to the company’s underlying value (aka discounted rate). The more insight into a company’s financials you have, the simpler it is to do.
With so many variables though, it’s easy to see why pricing a deal can be difficult and why most investors and transaction advisors choose to use multiple types of valuation models to inform their decision-making along with DCF analysis. An accurate answer helps inform how much an investment is currently worth—and which deals are worth walking away from.