1. Discounted Cash Flow Overview
Investors often need to determine what they should pay today to buy an
asset that generates one or a series of cash flows in the future.
In other words, investors need to value the asset. Examples include having
to value stocks, bonds, derivatives, or even another company.
One of the most common ways of valuing an asset is to use
discounted cash flows or DCF for short. The DCF principle is based on
the idea that the value of an asset today is the present value
of all as expected future cash flows. DCF can be applied to many
different scenarios, all of which are slightly different perspectives on
valuing an asset. A company may need to decide whether to invest in a
piece of equipment, which is an asset to their company.
Discounted cash flows can help them make this decision. A person might be
looking to invest in a product that gives them a steady income stream
in retirement. This product is an asset, again, to the investor,
and DCF can help them make a choice between products.
A bank might be looking to underwrite a loan to a client.
A loan is an asset to the bank, and discounted cash flows can
help the bank price and model the cash flows of the loan. In
this chapter, we'll explore these scenarios using the DCF framework to value
these assets. We've already done quite a lot of ground work to understand
DCF, but let's just recap some critical ideas.
2. Let's practice!