The second of three population methods of valuation is the discounted cash flow (DCF) method. In starting your own business, as discussed in the last post https://zachmunns.wordpress.com/2014/05/31/startup-valuation-1-of-3-net-present-value/, the valuation of your startup is extremely important. Undervaluing your company can can lead to a misrepresentation of your business and result in a lack of funding, lack of support, all leading to a lack in performance by the company.
The DCF method of valuation uses future free cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value, which is used to evaluate the potential for investment. The equation is as follows:
The purpose of this model is to estimate the capital return on a given investment based on the associated risk as well as adjusting for the time value of money. DCF is a useful tool with the right inputs such as accurate A/F forecasting ratios and appropriate discount rates. Without the proper inputs, the DCF method is rendered essentially useless. Be sure you understand your forecasts and their meaning before taking this approach.