Getting Started With Discounted Cash Flows

It's also important to remember that numbers aren't static -- they change over time. Don't put too much stock in DCF valuations that might be out of date. A perfectly valid valuation made three years ago might not be at all in line with a company's present day value.

DCF valuations represent long-term projections, so don't fall into the trap of thinking that just because a company is supposedly overvalued it isn't a good short-term investment. Discounting cash flows mainly deals with assessing a company's fundamentals and doesn't take into account the technical issues that might send a "bad" stock's price soaring in the short run.

DCF Methods Vary

The methods used for discounting cash flows can vary depending on the type of investment you're trying to value. Here are a few popular uses for DCF.

Bonds. One of the central elements of bond valuation is the use of discounted cash flows. With the bonds, though, the numbers are a lot more concrete. Troyer says, "The bond market is essentially a giant DCF engine. It's the same way with stocks, but the numbers aren't as scientific." Why? With a bond, variables like number of periods, future cash flow, and discount rate (coupon in the case of a bond), are all given and don't change.

Despite the fact that the discounting of bond cash flows are generally factored into the bond's pricing, if you're into bonds, then understanding DCF is a must.

Stocks. Stocks are an area where DCF is a popular tool. The stock market is also a place where poorly thought-out DCFs can lose big money.

Stocks have added elements of confusion when it comes to DCF since they don't have the static numbers that bonds do. Because of this, calculating discounted cash flows for equities adds an extra element of risk that's actually taken into account in more complex DCF equations.