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He may be suggesting that you buy some Dohar Cattle Feed Company stock (that's what I get when I search Google Finance for 'DCF'), but it's probably a reference to discounted cash flow, a very useful tool for evaluating certain business. The idea of DCF is to split up the value of an investment into chunks of future cash flow, and ask yourself how much you'd pay for each chunk. For a simple example, if you have a business that's sure to pay you $100, once, a year from now, you ask yourself: how much would I have to put in the bank, now, to get $100 on that date? That amount is the present value of that cash flow. Now consider a business that will pay that same certain $100, but after two years. The principle is the same -- how much would you put into a bank account now to get that same $100 on the same date? To further complicate things, imagine that you're betting on a coin flip: two years from now, you will get either $100 (heads) or $0 (tails). To figure out the net present value, you'd first determine the average outcome ($50), then decide how much you'd have to put in a risk-free account now to get that amount in two years.* Put these together, and you can understand the DCF framework. Let's say you have a business that earned $100 last year, and that you expect to earn about 5% more each year thereafter. But in any given year, there's a 10% chance that the business will go under. The discounted future value is that same procedure, repeated for each year: the price you should pay is how much you'd invest in a bank account now for a 90% chance of $105 in a year, plus an 81% chance of $110.25 in two years, etc., or sum(100 * 1.05^n * .9^n * [1 - risk-free interest rate]^n). So now all you have to do is 1) figure out what the business will earn every year from now until the end of time, and 2) figure out the intrinsic value of a given sum of money to be delivered at a given future date. These are both, of course, impossible. But rough estimates get you pretty close to where you need to be, and it provides a good way to compare two stable-growth businesses in the same industry (how much should you pay for a soft drink company growing at 3% each year, versus an otherwise identical company growing at 5% each year, for example?). * This assumes you have an infinite tolerance for risk. But a one in a billion chance of one billion dollars is probably not worth a dollar -- or, rather, it's worth more than a dollar if you enjoy gambling, and less than a dollar if you intend to retire on it. Edit: replaced a second '$105' with the correct number, $110.25. |