Digging into the Discounted Cash Flow Analysis

Investment bankers don't have crystal balls. But they might have something that's almost as handy, and something you can use, too: discounted cash flow analysis.

A discounted cash flow (DCF) analysis is a way investment bankers (and other financial types) put a price tag on a company. The DCF analysis is used by research analysts to tell investors whether a stock is a good buy. The DCF is also used by investment bankers when deciding a fair price to recommend buying or selling a company.

Knowing how the DCF analysis process works is very important for you because it's at the epicenter of how Wall Street works. Wall Street is all about putting prices tags on everything. And if you're pitched a stock or other investment, and you're told it's a "fair value," you'll want to know how the DCF analysis was used to make that claim.

The DCF analysis isn't difficult, but it does take a bit of tenacity to get all the information and perform the analysis. The goal of the DCF is to measure how much an asset, which will generate income and returns over many years, is worth right now. Getting to that answer requires the use of some gnarly looking formulas.

But all you really need to know is that the DCF analysis starts with an estimate of how much cash flow the investment will generate in the future, usually for at least five years out. Those estimated future cash flows are then discounted, or adjusted to reflect the value of money over time.

Discounted cash flows analysis might sound tricky, and to do them right requires much practice and knowledge about a company and its industry. But don't be fooled into thinking that just because an analyst or investment banker did a DCF analysis, the price tag put on the company is accurate. The DCF analysis is highly sensitive to just a few variables, especially the discount rate, or the value placed on money in the future. An investment banker can easily increase or decrease the estimated value of a company just by making a few adjustments to the numbers in the calculation.

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