What is the primary purpose of discounted cash flow (DCF) analysis?

The primary purpose of discounted cash flow (DCF) analysis is to estimate investment value based on future cash flows. This method involves projecting the expected cash flows that an investment will generate over time and then discounting those future cash flows back to their present value using an appropriate discount rate. This process allows investors and analysts to determine whether an investment is undervalued or overvalued in the current market.

DCF analysis is particularly useful because it focuses on the intrinsic value of an investment rather than market sentiment or price fluctuations, which can be influenced by various external factors. By using cash flows, which represent the actual money that an investment is expected to generate, DCF provides a more accurate and objective assessment of an investment's potential profitability.

In contrast, comparing companies' stock prices does not inherently take the time value of money into account, and calculating dividend yields focuses solely on dividends rather than the overall cash flow generated by the company. Assessing market trends typically involves analyzing broader economic indicators and may not provide insights into the specific value of an investment based on its cash flow. Thus, estimating investment value through future cash flows is what distinctly characterizes DCF analysis.