Intrinsic Value – Application of Discounted Cash Flows
Every student of investing is taught the core principle of discounted cash flows. This business principle is also used with intrinsic value. Application of discounted cash flows assists value investors with determining intrinsic value. Academia, major investment brokerages and the majority of investment websites place unquestionable belief in this single formula to equate value for a security. The problem is that all of them forget or ignore the underlying requirements to use and then, rely on the outcome of the formula’s solution. In effect, with intrinsic value and the application of discounted cash flows, there is a very narrow set of highly defined parameters whereby this tool is applicable and useful. Used outside of this framework, the result’s reliability quickly drops to nearly zero, similar to how the bell curve moves from the most likely outcome in the center to extremes on either side.
Look at this bell curve. Application of discounted cash flows can produce an excellent solution contingent on NO or limited deviation from the norm (the highest point in the curve). This article starts out by identifying the highly restrictive requirements to apply discounted cash flows. There are at most 20% of all marketable securities where this formula succeeds in determining intrinsic value. Secondly, the formula is explained to the investor and why it is so important to apply it properly. There are several terms and values the user must include in the formula; this section explains them in layman’s words.
The third section below goes into the corporate financial matrix to explain how to determine cash flows. Furthermore,
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