Mention any of a handful of financial computation terminology in any audience and you are prone to get glazed eye stares. People are brought up to think that anything that has to do with finance is quite hard or it is beyond their grasp. The complete opposite is true. Quite a few, once explained to someone in commonsense terms, are easily comprehended. The fact is, many individuals actually calculate and take into account many “finance terms” without even knowing they are doing it. Discounted cash flow DCF is one.
So what exactly is a discounted cash flow analysis? Just by the terminology, it sounds complicated. In simple terms, it is computed by taking the cash generated by a enterprise through sales or other means after which factoring in the risks to that cash generation down the road.
Most business owners are aware of the discounted cash flow analysis, although they might not think of it as such. Enterprise owners are always thinking about the future. They examine the competition and their ability to generate money in the competitive world. Furthermore, they monitor what the present and potential economy is predicted to be and any variations within the price of materials and labor. At the end of the day, cash flow (aka: capital) is exactly what matters. It just took some finance guys to slap a fancy term like the discounted cash flow analysis.
Now you know what a discounted cash flow ( DCF) analysis is, but do you know the factors that go into computing it? Usually the discounted cash flow DCF is performed on the project basis, which may then be summed up for a company as a whole if one wishes to take it that far. The three main elements are free cash flow, the terminal value at the end of the free cash flow time period being assessed, as well as the discount rate used on future predictions.
Here is a simple example, which excludes terminal value, but serves this purpose. If a person were to tell you they would give you $10,000 each year for the following 10 years, or $25,000 today, which is a better deal? If there was one hundred percent chance this person will be capable of paying the yearly payment in full, then the yearly payout is clearly worth more. But what happens if after year 4, the chances that person is able to pay you drops down to 30 pct? This is specifically why calculating the discounted cash flow discounted cash flow is significant. It helps companies invest wisely and enables banks along with other investors to value elements of a business.