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The basic investment valuation model
The basic valuation model lies at the heart of all investment decisions and, as such, is an important concept to understand.
It will give you a bedrock against which to make all investment decisions, whether regarding shares, property, or bonds. It will assist you to make dispassionate investment decisions, to avoid getting caught up in hype.
So, what is this magic model? The basic valuation model is the discounted cash flow model: quite simply, the value of ANY investment is the sum of its future cash-flows.
The future cash-flow for a single year is written algebraically as Ci/(1+r) (where C equals the cash flow, i is the year and r is the discount rate). For example, if you receive $100 in one year's time, the present value of the cash flow is $90.91, if it was discounted back at a rate of 10%. That is, 100 = 90.91/(1.1)
Therefore, the value of an investment is the sum of all future cash-flows, discounted at an appropriate rate.
There are three important concepts on which the discounted cash flow model is premised.
Of course, you then have to go and identify what those cash flows are. Over time, we will help you build models which will assist you in forecasting the future cash flows for shares, residential property and other investments.
Here endeth the lesson of Finance 101.