Discounted cash flow (DCF)

Definition

Discounted Cash Flow (DCF) is a valuation method used to estimate the value of an investment based on its expected future cash flows. The future cash flows are adjusted for the time value of money using a discount rate.

5 Must Know Facts For Your Next Test

1. DCF involves projecting future cash flows and discounting them back to their present value.
2. The discount rate typically reflects the investor's required rate of return or cost of capital.
3. A higher discount rate results in a lower present value, indicating higher risk or desired returns.
4. DCF can be used to evaluate stocks, bonds, real estate, and other investments.
5. One common model used within DCF for valuing stocks is the Gordon Growth Model, which assumes constant growth in dividends.

Review Questions

• What is the purpose of using a discount rate in DCF?
• How does changing the discount rate affect the present value in a DCF analysis?
• Which model within DCF assumes constant growth in dividends for stock valuation?

Related terms

Present Value (PV):

The current value of future cash flows discounted at the appropriate discount rate.

Cost of Capital:

The return rate that investors expect from an investment given its risk.

Gordon Growth Model:

A DCF method that values a stock by assuming constant growth in dividends indefinitely.