Valuation And Fundamental Analysis · Intermediate · 8 minute read · No ads
Discounted Cash Flow (DCF)
Also called DCF valuation, discounted cash flow valuation, intrinsic value model
Discounted cash flow, or DCF, estimates value by forecasting future cash flows and converting them into today’s dollars with a discount rate. Add the present values, adjust enterprise value for debt and cash, then divide equity value by shares when estimating value per share.
Key takeaways
- DCF links value to the cash an investment may produce, not simply to its current market price.
- Cash flow and discount rate must match: free cash flow to the firm pairs with the weighted average cost of capital, while free cash flow to equity pairs with the cost of equity.
- Terminal value often represents a large part of the result, so its growth and exit assumptions deserve extra scrutiny.
- A DCF is a range based on assumptions, not a precise forecast or a promise of future returns.
What is discounted cash flow?
Discounted cash flow, or DCF, estimates what an asset or business is worth today by forecasting the cash it may generate and discounting each future amount for time and risk. A company DCF usually values operating cash flows first, then adjusts for debt, cash and other claims to reach an estimated equity value.
How Discounted Cash Flow (DCF) works
| Step | What happens |
|---|---|
| 01 · Choose the valuation route | Decide whether to value the enterprise with free cash flow to the firm or equity with free cash flow to equity. |
| 02 · Forecast operating cash flow | Build a defensible forecast for revenue, margins, taxes, reinvestment and working capital. |
| 03 · Estimate the terminal value | Use a sustainable perpetual growth assumption or a supportable exit multiple after the explicit period. |
| 04 · Discount and reconcile | Discount every cash flow, add the present values, then adjust enterprise value for debt, cash and other claims before calculating value per share. |
The formula
DCF value = Σ CFₜ ÷ (1 + r)ᵗ + TV ÷ (1 + r)ⁿ
CFₜ = expected cash flow in period t r = discount rate that matches the cash flow and its risk t = number of periods until the cash flow occurs TV = terminal value after the explicit forecast n = final explicit forecast period
A worked DCF example with numbers
Assume a company is expected to produce free cash flow to the firm of $10 million in year one, $11 million in year two and $12 million in year three. An analyst estimates a terminal value of $180 million at the end of year three and uses a 10 percent discount rate.
The present values are about $9.09 million, $9.09 million, $9.02 million and $135.24 million. Together they produce an estimated enterprise value of $162.44 million.
If the company has $20 million of cash and $40 million of debt, estimated equity value is $142.44 million. With 10 million diluted shares, the simplified value per share is about $14.24. This result is only as reliable as the cash flow, terminal value, debt, cash and share count assumptions.
Why it matters
DCF forces an investor to state what must happen for a valuation to make sense. Instead of saying a stock looks cheap, the model identifies the cash flow growth, reinvestment, risk and terminal assumptions behind that conclusion.
Use the DCF Valuation Tool to test several scenarios. Change one input at a time and compare a cautious case, a central case and an optimistic case. The tool is educational and does not provide a price target or investment recommendation.
Before forecasting cash, review how operating cash flow, capital expenditure and the cash flow statement connect.
Turn the formula into a model
Enter an explicit forecast, choose a discount rate and compare scenarios. The tool shows how each assumption changes estimated value.
- No signup required
- Change assumptions instantly
- Educational estimates only
Want to keep learning valuation? Start the free course
Match the cash flow and discount rate
A company DCF can value the whole business or only the equity. Free cash flow to the firm is available to debt and equity investors, so it is discounted at the weighted average cost of capital. Free cash flow to equity is available only to common shareholders, so it is discounted at the cost of equity. Mixing the two creates a valuation error.
| Valuation route | Cash flow | Discount rate | Result |
|---|---|---|---|
| Enterprise value | Free cash flow to the firm | Weighted average cost of capital | Value of the operating business before net debt |
| Equity value | Free cash flow to equity | Cost of equity | Value attributable to common shareholders |
Build the explicit forecast
The explicit forecast should connect revenue, margins, taxes, reinvestment and working capital to cash flow. Forecasts normally become less precise further into the future. Use assumptions that can be explained from company filings, industry economics and operating history rather than extending one unusually strong year forever.
Treat terminal value as an assumption, not a plug
Terminal value represents cash flows beyond the explicit forecast. A perpetual growth approach divides the next period cash flow by the discount rate minus a sustainable growth rate. An exit multiple approach applies a market multiple to a future operating measure. Either approach can dominate the answer, so show its share of total value and test a reasonable range.
Read a sensitivity table
A single DCF result can create false confidence. A sensitivity table changes the discount rate and terminal assumption to show a range of values. If a small change produces a very large movement, the conclusion is fragile. Compare the range with the market price and ask which assumptions the price already implies.
What DCF can and cannot tell you
DCF is useful when cash flows can be estimated with some reliability. It becomes harder for early stage, deeply cyclical or distressed companies whose cash flows and financing needs are uncertain. The model does not remove uncertainty. It organizes uncertainty so the investor can see it.
Comparison
| Aspect | DCF valuation | Relative valuation |
|---|---|---|
| Main question | What are the expected cash flows worth today? | How is the company priced against comparable businesses or its own history? |
| Core inputs | Cash flow, timing, discount rate and terminal value | A chosen metric, comparable companies and an appropriate multiple |
| Main strength | Makes operating and risk assumptions explicit | Fast and grounded in observable market prices |
| Main weakness | Highly sensitive to forecasts and terminal assumptions | Comparable companies may differ in growth, risk, margins and capital structure |
Check yourself
Which pairing is internally consistent in a company DCF?
Free cash flow to the firm belongs to debt and equity investors, so the weighted average cost of capital is the matching discount rate. Equity cash flow instead pairs with the cost of equity.
Show the answer
Free cash flow to the firm discounted at the weighted average cost of capital
Things people get wrong
Mistake 01 Mixing cash flow and discount rate
Discounting free cash flow to the firm at the cost of equity, or free cash flow to equity at the weighted average cost of capital, produces an inconsistent result.
Mistake 02 Hiding the terminal value
A terminal value that makes up most of the result is not automatically wrong, but the growth or multiple assumption must be visible and tested.
Mistake 03 Presenting one precise answer
Forecasts are uncertain. A valuation range and sensitivity table are more honest than a value stated to the cent.
Questions people ask about Discounted Cash Flow (DCF)
What does DCF stand for?
DCF stands for discounted cash flow, a method that converts expected future cash flows into an estimated value today.
Why are future cash flows discounted?
Money available later is worth less than money available today, and uncertain cash flows require compensation for risk. The discount rate reflects both ideas.
What discount rate should a DCF use?
It depends on the cash flow. Free cash flow to the firm normally uses the weighted average cost of capital, while free cash flow to equity uses the cost of equity.
What is terminal value in a DCF?
Terminal value estimates all cash flows after the explicit forecast. It is commonly calculated with a perpetual growth formula or an exit multiple.
Is a higher discount rate better or worse for value?
A higher discount rate reduces present value because future cash flows are divided by a larger amount.
How many years should a DCF forecast?
The explicit period should be long enough for the company to move toward a stable operating state. Five to ten years is common, but the right period depends on the business.
Can a DCF value a company with negative cash flow?
It can if the company is expected to reach positive cash flow and the path can be estimated, but uncertainty and financing risk make the result more fragile.
Is DCF the same as a stock price target?
No. A DCF is an estimate based on assumptions. It should be compared with other methods and updated when facts or expectations change.
The bottom line
Discounted cash flow estimates value by forecasting cash flows, discounting them for time and risk, and adding their present values. The method is powerful because it exposes assumptions, but it is not precise. Match the cash flow to the discount rate, scrutinize terminal value, reconcile enterprise value to equity value and use a range rather than one confident number.
Sources
- Aswath Damodaran, An Introduction to Valuation
- Aswath Damodaran, Present Value Primer
- US Securities and Exchange Commission, Beginner’s Guide to Financial Statements
- Aswath Damodaran, Getting to Equity Value Per Share
- Aswath Damodaran, Reconciling DCF and Relative Valuation
How we produced the figuresThe worked example discounts $10 million, $11 million, $12 million and a $180 million terminal value at 10 percent. The enterprise value is the sum of those present values. The equity bridge adds $20 million of cash and subtracts $40 million of debt, then divides by 10 million diluted shares. Taxes, leases, minority interests, pension obligations and other adjustments are omitted for clarity.
Build your own valuation range
Use the free DCF tool to test cash flow, growth, discount rate and terminal assumptions. No signup required. Estimates are educational, not forecasts.
About this page. Written by Associate Professor Charles Lo, CPA, PhD and edited by Felix La Spina. Checked against reliable sources before publication. No ads and no paywall. Editorial standards · How we fact check · Corrections log · Report an error
Educational information only. Nothing on this page is personal financial, tax or legal advice. Investing involves risk, including the possible loss of principal.
