What does the "discounted earnings method" estimate in valuation?

The discounted earnings method estimates a firm’s value by focusing on its future earnings and converting those earnings into their present value. This approach hinges on the principle that money available today is worth more than the same amount in the future due to its potential earning capacity.

In this method, future earnings projections are developed based on various assumptions regarding growth rates and profitability. These earnings are then discounted using a specific rate, typically reflecting the risk associated with the investment, to determine what those future earnings are worth in today’s terms. This evaluation is crucial because it allows investors to assess the potential return on investment and determine if the current pricing of a firm’s equity accurately reflects its financial health and growth potential.

Thus, the discounted earnings method provides a forward-looking perspective that accounts for expected performance rather than solely relying on historical data or current assets, which sets it apart from other valuation approaches.