A computational tool used to determine the present value of an investment based on its expected future cash flows. This tool uses a mathematical formula to discount future cash flows, reflecting the time value of money. It’s commonly employed to evaluate the potential profitability of a project, business, or investment opportunity. An instance of its use involves estimating the worth of a company by forecasting its future free cash flows and discounting them back to their present value using a predetermined discount rate.
The utility of this approach stems from its ability to provide a theoretically sound estimate of intrinsic value. By quantifying the present value of expected future cash flows, it allows for a more informed investment decision, mitigating risks associated with purely speculative valuations. Its historical roots lie in the fundamental principles of finance, where the value of an asset is inextricably linked to its capacity to generate future returns. This method gained prominence as a sophisticated alternative to simpler valuation metrics, offering a more nuanced assessment of investment prospects.
