From the course: Financial Modeling and Forecasting Financial Statements

Use financial forecasts to make investment decisions

From the course: Financial Modeling and Forecasting Financial Statements

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Use financial forecasts to make investment decisions

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The fundamental model for estimating the value of a business or any other asset is called discounted cash flow analysis, or DCF for short. For example, to use DCF in estimating the value of a piece of commercial real estate, you would estimate the annual net cash flows to be generated by the property, plus the amount for which the real estate could be sold at some terminal period. All of these cash flows would then be discounted to the present using an appropriate interest rate. Wow, yee, that sounds difficult. Well, let's take it step by step, and we'll start with the time value of money. The concept of the time value of money can be summarized as follows. Money now is worth more than the same amount of money to be received in the future. It is essential to adjust for this time value of money when estimating the value of an asset, such as a business or a piece of commercial real estate, because that asset will generate cash flows far into the future. And a dollar received far into the future is worth less than a dollar received now. This is exactly what interest rates do. They allow us to adjust for differences in the time value of money. A DCF, or discounted cash flow analysis, requires that we have a number for the interest rate so that we can do the discounting, and also that we have forecasts for the cash flows. We can use the structure of accounting to create a disciplined forecast of the future cash flows for a business. In doing a discounted cash flow or DCF analysis, there are three important questions to ask as you conduct this business valuation. First, how large will be the future cash flows? Second, when will those cash flows occur? And third, how risky are those cash flows? Now, let's consider each one of these questions. First, how large will be the future cash flows? Your intuition tells you that the more cash that will be generated by a business in the future, the more valuable is that business. As of August 2025, why is Apple worth $3.4 trillion, but Kodak is worth only $484 million. The primary reason for the difference is that Apple is expected to generate much larger cash flows in the future. So the larger the cash flows a business will generate in the future, the more valuable the business. By the way, notice that I keep referring to the future. The reason is that when you buy a business or invest in a business, you are buying the future, not the past. The past is of interest only to the extent that the past results can help you in forecasting future results. Now second, when will those cash flows occur? Recall that a dollar received far into the future is worth less than a dollar now. So as we do this valuation, we must be careful to forecast the timing of the future cash flows. And third, how risky are those cash flows? Risk is an uncertainty about what will happen in the future stemming from variability and potential future cash flows. Now, in general, human beings don't like risk. Therefore, very risky future cash flows are worth less to me than our relatively safe future cash flows. In our discounted cash flow analysis, or DCF, we will adjust for this riskiness through our choice of the interest rate. With more risky future cash flows, we demand a higher return on our investment, so we will use a higher interest rate in our analysis. Now, to review, the three things we must consider in doing a discounted cash flow or DCF analysis are as follows. How large will be the future cash flows? When will those cash flows occur? How risky are those future cash flows? The estimation of all three of these things requires careful financial modeling and forecasting. So financial modeling is fundamental to investors.

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