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In this video we will understand how analysts utilize the DCF method to estimate the value of an Asset.
DCF stands for Discounted Cash Flow. It is a method used to evaluate how much the value of an investment should be worth based on how much money it will generate in the future.
The main purpose of this method is to adjust all future cash flows based on the theory of Time Value of Money.
Under this theory, it is assumed that the value of money always depreciates over time.
Time value of money assumes that the value of 1 rupee today will not be the same 1 year from now.
Let us explain this to you with the help of an example:
If you have Rupees One Hundred in your savings bank account today and the bank is offering a guaranteed return of 5%.
Then it can be said that after 1 year, that one hundred will become rupees one hundred and five.
But if you kept that money in your wallet and left it there for 1 year, the present value would then become Rupees Ninety Five.
The key reason being inflation. Inflation is the general rise in prices of goods and services over time.
A bag of crisps go for Rs.10 today, but the same amount of chips would sell for Rs.5 10 years ago.
Investors can use this concept of time value of money to determine if future cash flows are greater than the value of the asset.
If the value calculated through the DCF method is higher than the current asset cost, then the asset is a good value buy.
The interpretation of this fact is that if the company continues the operations as per current plans, the present value of it’s future cash flows is more than the market price and hence it makes sense to buy it at a cheaper value now.
But similarly, if the value of the asset turns out to be higher than that calculated, then the asset is said to be overvalued.
The DCF method can be applied to a number of things. Like
– Purchasing machinery or business equipment
– Valuing bonds
– Purchasing real estate properties
– Investing in Insurance or annuities
– Investing in shares of a company
Bear in mind, such valuation only works for assets that have the potential to generate future cash flows.
Also the asset needs to generate at least a positive cash flow once in the future. You do not need to value something that is never going to generate any profits.
Many startups have negative cash flows for the first few years, but VCs can still value it only based on the assumption that it will make profits in the future.
So one cannot use this model to calculate the price of a Picasso painting, because the value of an asset like that lies in the eyes of the beholder.
Now let us look at the pros and cons of this method.
A major advantage of this method is that it is an extremely detailed approach to investing. It is prepared after an extensive analysis of the financials of a company.
It can also be prepared on an Excel sheet, making it much easier than doing all the calculations manually.
When it comes to the cons of this method, a major limitation is that most of the data used to calculate the present value is based on many assumptions.
It can be a very accurate picture as the future cash flows depends on a number of factors such as demand, macroeconomic conditions and many more.
So this makes DCF valuation a better option for companies that have had steady growth in the past as the future cash flows can then be more predictable.
As opposed to newer companies or cyclical companies that have varying growth rates that depend on a number of factors.
Thank you for watching!
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