Using discounted cash flow analysis, financial analysts evaluate companies in terms of investment attractiveness. This allows you to get answers to very specific questions, for example, to determine the amount of investments in the project.
How discounting cash flows is used
Discounting cash flows is a valuation technique that determines the amount of future benefits. This method is used to determine the true value of the company, regardless of the prices and profits of competitive firms. Venture capitalists order discounted cash flow analysis to determine future return on investment.
Discounting is often used for real estate analysis. Not only cash flows are taken into account, but also other benefits: unrealized loss, tax credits, net proceeds. The purpose of discounting is to assess the possible economic benefits and calculate the amount of financial investments in the company.
Stages of applying discounted cash flows
Discounting occurs in six stages. First, it prepares accurate forecasts about the organization's possible future operations. The more accurate they are, the more investor confidence. Further, the positive and negative cash flows for each year of the forecast are estimated, and the annual growth of funds in the future is calculated. The final cost of the company for the last year of the forecasts is calculated. The discount factor is determined. This indicator is one of the key elements of cash flow analysis. It reflects the risks involved.
The discount factor is applied to the shortfall and surplus of funds in each year of the forecast and to the final cost of the project. The result is a value that determines the size of the contribution for each year. If you add these values together, you get the present value of the company. At the end of the analysis, the existing borrowings are deducted from the present value of future cash flows. In this way, an estimate of the current project cost is calculated.
Despite the technical complexity of the calculation, discounting cash flows relies on the simple idea that current cash is more valuable than future cash. That is, the return on financial injections will exceed the current value. It makes no sense to invest a hundred dollars in a project just to get the same amount in the future. Much more attractive is the idea of investing a hundred today in order to get a hundred and twenty tomorrow.
As with all valuation methods, discounting has disadvantages. The main one is that, focusing only on future cash flows, it ignores external factors - the ratio of income and share price, etc. In addition, since the method assumes accurate forecasting, it is necessary to have a very good knowledge of the history, market and nature of the business being evaluated.
