What Is a Discounted Cash Flow (DCF)?
A discounted cash flow model values a business as the sum of its expected future cash flows, each converted to today's dollars. How a DCF works, a worked example, and why small changes in assumptions move the answer so much.
In one sentence
Discounted cash flow (DCF). A way to estimate value by forecasting the cash a business will produce and converting it into today's dollars with a discount rate.
How it works
A dollar received in five years is worth less than a dollar today, because today's dollar could be invested in the meantime. A DCF forecasts the cash a business will generate, discounts each year's cash back to today at a rate that reflects the risk, and adds them up. For the years beyond the forecast, it adds a terminal value.
Value today of a future cash flow = Cash flow ÷ (1 + Discount rate) raised to the number of years
| Year | Cash flow | Value today |
|---|---|---|
| 1 | 100 | 90.9 |
| 2 | 110 | 90.9 |
| 3 | 120 | 90.2 |
| Terminal value: 120 × 1.03 ÷ (0.10 − 0.03) | 1,765.7 | 1,326.6 |
| Total | 1,598.6 |
Over 80% of the value comes from the terminal value: the years nobody can forecast in detail.
Why the answer moves so much
Change the growth rate after year 3 from 3% to 4%, and the total rises to about 1,835; cut it to 2%, and it falls to about 1,422. A one-point change in one assumption moves the value up by about 15% or down by about 11%. That's why a DCF is best read as a range, not a single number.
Learn it properly
- Discounted Cash Flow, Step by StepPart 4: Research and Valuation · Free