June 22, 2005

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Daily linklets 22nd June posted by Simon on 06.22.05 at 04:32 PM in the Daily linklets category.


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Let me elaborate a little more on my problem with discounted cashflows. The theory is there is a time value of money...you can think of this as how much would that money earn if it was stuck in the bank instead of that investment. The problem with it is the discounting is such that cash flows further into the future are virtually worthless (the exact point depends upon the interest rate used). Now if you're planning to drill an oil well that will last for 50 years, it is plainly ridiculous that the cash generated by the field in the last ten years is valued at very little. Discounted cashflow valuations work well on projects that have a short-ish life span (say less than ten years) and/or a comparitively low discounting rate. There's actually plenty of other problems with the method, such as determining an appropriate discount rate and dealing with changing inflation.

But so long as it's the dominant method taught in finance, that' what the vast majority are stuck with. Like all models it may give a good first cut but then you need to use your noodle. And people who do that are in short supply.

posted by: Simon on 06.22.05 at 06:07 PM [permalink]

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