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Discounted Cash Flow

How would you validate the future value of time, effort and risk if you could not use money as a barometer of success?

Quantifying future value based on weighting belief in collected narratives and thesis of how plans of action will impact outcomes that grow wealth.

Job to be Done​

A Discounted Cash Flow (DCF) model serves three primary purposes:

Valuation​

  • Determines the theoretical value or price of an asset, company, or investment
  • Helps assess whether a company's stock is undervalued or overvalued
  • Values income-generating properties like rental apartments or office buildings

Investment Decision Making​

  • Evaluates whether future cash flows exceed the initial investment amount
  • Assists in strategic decision-making for capital budgeting and operating expenditures
  • Compares different investment opportunities by converting future values to present-day equivalents

Risk Assessment​

  • Accounts for the time value of money and risk through the discount rate
  • Considers various scenarios including best case, expected case, and worst case outcomes
  • Helps assess potential impacts of economic factors, market conditions, and business cycles

The fundamental principle is that DCF helps determine if the money an investment might generate in the future is worth more than what needs to be invested today. This makes it an essential tool for making informed financial decisions across various business contexts.

Qualification​

Gather the best tools and hone skills to become a super-forecaster. Project forward to set a target, clarify a picture of success that resonates, then walk back along the flow of inputs and risks to justify the value of the journey ahead.

Identify domain boundaries then interview domain experts to reverse engineer their Job to be Done stories, then aggregate the narratives into a single story of best and worst case scenarios to weight your bets.

Domain Experts​

Gather people with first hand experience of how value flows.

Investigation​

danger

All you see is all there is.

Workflow​

The basic principle involves forecasting the future cash flows of the business and then discounting them back to their present value.

Forecasting Cash Flows: This involves projecting the business's future cash flows. This projection should be realistic and based on both historical data and future prospects of the company. It's important to consider various factors like revenue growth, profit margins, capital expenditures, and working capital requirements.

Selecting the Discount Rate: The discount rate is a critical component of DCF analysis. It reflects the riskiness of the cash flows and often incorporates the cost of capital. A common approach is to use the Weighted Average Cost of Capital (WACC).

Terminal Value Calculation: Since forecasting cash flows far into the future is challenging, a terminal value is often calculated. This value represents the business's value at the end of the projection period and is usually calculated using either a perpetual growth model or an exit multiple.

Sensitivity Analysis: Given the uncertainties in forecasting, it's crucial to perform sensitivity analysis. This involves changing key assumptions (like growth rates, discount rates) to see how they affect the overall valuation.

Consideration of Non-financial Factors: While DCF is a financial model, it's important to consider non-financial factors such as market trends, competitive landscape, regulatory environment, and management quality.

Validation of Assumptions: The assumptions made in the DCF model should be validated with real-world data and trends. Unrealistic assumptions can lead to significant errors in valuation.

Challenges and Limitations: DCF analysis can be complex and is sensitive to inputs. It requires precise forecasting, which can be difficult, especially in volatile or unpredictable markets. Understanding these limitations is crucial for accurate valuation.

Regular Updates and Revisions: As new information becomes available, it's important to update the DCF model. Changes in market conditions, company performance, and economic factors can all impact the valuation.

Context​