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Discounted Cash Flow Analysis

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Discounted cash flow analysis is a valuation tool analysts use to evaluate the attractiveness of investment opportunities. Discounted cash flow analysis projects the cash flows an investment will generate in future years, then applies a discount rate to the cash flow stream to derive a present value for the investment. The company's weighted average cost of capital is the discount rate used in applying discounted cash flow analysis to stocks. A variation of discounted cash flow analysis sometimes used by equity analysts is the dividend discount model which uses dividends instead of cash flow. Discounted cash flow analysis is a powerful valuation tool but does have drawbacks. A major issue with discounted cash flow analysis is the difficulty of estimating future cash flows. Also, small input changes cause the discounted cash flow analysis to yield drastically different results.



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