How The Discounted Cash Flow (dcf) Can Predict Stock Returns

The discounted cash flow (DCF) analysis is like a crystal ball into the future of stock prices. Although no one can truly predict stock prices, the DCF method helps determine which companies will preform the best going forward. Whether an investor wants to find the next great internet company or short specific sectors in the stock market, the DCF is a valuable tool for any stock market expert.

The discounted cash flow (DCF) analysis is a cash flow analysis discounted by a rate that equates to the risk of the investment. When prognosticating future growth, it is important to discount for inflation, credit and other risk factors that could negatively affect an investment. The discount factor makes future predictions of sale, profits and cash flow comparable to what those figures could buy in today's dollars.

In order to put a company's forecasts into present value terms, an inflation rate is assumed for the future time period being analyzed. Usually, this amounts to looking at the historical inflation rates over the last ten or twenty years to determine an average rate that is then applied to future projections.

Imagine you have a project where sales were $100 this year and will be $120 dollars next year. This increase sounds great until an investor examines the inflation rate and discovers that it will increase by 15% next year. The real rate of increase in sales is only $5 and not $20, because of inflation. The discounted cash flow analysis adjust for inflation risk.

Discounted cash flow (DCF) analysis applies this concept to projected P&L and Cash Flow statements to determine the amount of 'free' cash flow being generated. Free cash flow allows a company to pay dividends and/or grow without having to borrow more money. The net affect to shareholders is increased value of their investment. Obviously, the opposite is true where the free cash flow is diminishing or negative.

DCF is an invaluable tool but taking the time to compute it on every company we are considering for investment can require more time than we have available. Rather than making a decision without this vital information, visiting http://www.wikiwealth.com/dictionary:discounted-cash-flow can save time and provide in depth analysis for today's investors.

About the Author:
Looking to find the best tools to invest in stocks, then see WikiWealth.com's discounted cash flow analysis. www.wikiwealth.com is the address for thousands of free DCF analysis reports.

Article Originally Published On: http://www.articlesnatch.com

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