From the course: Investment Evaluation

What is DCF? - Microsoft Excel Tutorial

From the course: Investment Evaluation

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What is DCF?

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- You've already met Kevin, the president of two successful businesses. Let's imagine that he's in a bit of situation. Looks like he has some excess money lying around. Hey, good for him. Another business down the road has offered him a private deal. An opportunity to buy a 10% stake in that business. The business has an annual growth rate of about 2.5% per year and is looking to produce about a million dollars in free cash flows in the upcoming year. So if Kevin has a 10% stake in that business, he's looking at 100K in free cash flows next year. What should Kevin pay for that 10% stake? You can maybe even intuitively figure out how to solve this problem. You already know that Kevin's gonna have to take several things into account. Most importantly, the time value of money. Also, he has to trust the market and the company will continue to perform at the same level over time. So, the technique that Kevin should be using is something called Discounted Cash Flow Analysis. The formula for the analysis looks like this. Pretty straightforward, right? Let's break it down so you know exactly what you're looking at. The DCF is a sum of all future discounted cash flows. This is essentially what Kevin is solving for when he looks to determine what his investment amount should be today if the business were to keep up in the future. It's basically the valuation of the business. The CF is a net cash flow for a given year. The subscript represents a year in which the cash flow is calculated. The R is the discount rate and of course it's in decimal form. Got it? Good. Let's move forward and solve this equation to see what Kevin should pay for this potential investment.

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