A beginner's guide to discounted cash flow (DCF) valuation

What is a business worth? One of the most widely used answers comes from discounted cash flow, or DCF, analysis. This page explains the idea behind it, the main steps and why it needs careful use.

Quick answer

Discounted cash flow (DCF) is a valuation method that estimates what a business is worth today based on the cash it is expected to generate in the future. Because money received later is worth less than money today, each future cash flow is reduced, or discounted, using a rate that reflects risk. The sum of these discounted cash flows, plus a terminal value, gives an estimate of intrinsic value.

Key takeaways

• DCF values a business from its expected future cash flows.
• Future cash is discounted because money today is worth more.
• The discount rate is often the WACC.
• Terminal value usually makes up a large part of the result.
• Small changes in assumptions can change the value a lot.

What is discounted cash flow valuation?

The idea rests on the time value of money. Rs 100 today is worth more than Rs 100 in five years, because today's money can be invested and because the future is uncertain. A DCF converts future cash into today's value so it can be added up fairly.

The method focuses on cash, not reported profit, because cash is what a business can actually pay to its owners and lenders. Analysts usually use free cash flow for this.

The main steps

After finding enterprise value, you subtract net debt to get equity value, then divide by the number of shares to get a value per share.

A very simple example

Suppose a business is expected to produce free cash flow of Rs 100 crore next year, and you use a discount rate of 12 percent. The present value of that one year's cash is 100 divided by 1.12, or about Rs 89 crore.

Cash expected in the second year would be divided by 1.12 twice, and so on. Adding up all these present values, plus the discounted terminal value, gives the estimate of what the business is worth today.

What are the weak points?

The result depends heavily on assumptions about growth, margins, the discount rate and the terminal value. The terminal value often makes up more than half of the total, so small changes in long-term growth can swing the value a lot.

It is also hard to forecast cash flows for young, fast-changing or cyclical companies. For banks, analysts often use other methods, because their cash flows work differently.

How investors use DCF

Many investors use a DCF to check whether a share price looks reasonable compared with a sensible range of values. Running several scenarios, such as base, good and bad cases, shows how sensitive the answer is.

In short, discounted cash flow is a structured way to link a company's future cash to its value today. It is a useful tool for thinking, not a precise answer or a buy or sell signal.

Frequently Asked Questions