What is discounted cash flow (DCF)?
– Discounted cash flow is a valuation approach that converts an investment’s expected future cash receipts into a single present value. The method asks: what are those future payments worth today once you account for the fact that money today can be invested and earn a return?
Key definitions
– Cash flow: the actual cash expected to be received (or paid) in a period.
– Present value (PV): the current worth of a future cash flow after discounting.
– Discount rate: the interest rate used to convert future cash flows into present value; it reflects the time value of money and required return.
– Net present value (NPV): the sum of discounted cash flows minus the initial outlay. NPV > 0 implies the project’s discounted returns exceed its cost (all else equal).
– Weighted average cost of capital (WACC): a common discount rate used by firms; it is the average required return across the firm’s sources of capital (debt and equity), weighted by their proportions.
How DCF works (conceptual steps)
1. Forecast the project’s or asset’s future cash flows for a suitable horizon (yearly, quarterly, etc.).
2. Select a discount rate that reflects the risk and opportunity cost of capital (e.g., WACC for company projects).
3. Discount each forecasted cash flow back to today using the discount rate.
4. Estimate the terminal or end value if cash flows extend indefinitely or beyond the forecast window.
5. Sum the discounted cash flows (and discounted terminal value) to get the asset’s present value.
6. Subtract initial investment or required capital to obtain NPV. Use NPV to inform go/no-go or valuation decisions.
DCF formula
PV of a series of cash flows:
PV = CF1/(1 + r)^1 + CF2/(1 + r)^2 + … + CFn/(1 + r)^n
where:
– CFt = cash flow in period t
– r = discount rate
– n = number of periods
Step-by-step checklist before you build a DCF
– Define the forecast horizon (how many years you will explicitly model).
– Prepare realistic cash-flow projections (revenues, expenses, taxes, changes in working capital, capex).
– Choose an appropriate discount rate and justify it (WACC, required rate for the investor, or a risk-adjusted rate).
– Decide how to handle the terminal value (e.g., constant-growth perpetuity or exit multiple) and document assumptions.
– Run sensitivity analysis on key inputs (growth rates, discount rate, margins).
– Compare the DCF outcome to market prices and other valuation methods as a reality check.
Advantages and limitations (short)
Advantages
– Focuses on cash generation, the metric investors ultimately receive.
– Flexible: can be adjusted for project- or company-specific risks and time horizons.
– Useful for capital budgeting and buy/sell decisions.
Disadvantages
– Highly sensitive to input assumptions (growth rates, discount rate, terminal value).
– Requires credible forecasts; poor or biased estimates lead to misleading valuations.
– Can give a false sense of precision if uncertainty is not reported (e.g., via sensitivity/scenario analysis).
Worked numeric example (project-level NPV illustration)
– Company discount rate (WACC): 5%
– Initial investment: $11,000,000
– Project horizon: 5 years
– Present value of the project’s forecasted cash flows (sum of discounted cash flows
) — calculated by discounting each year’s projected free cash flow (FCF) to the present and summing. Net present value (NPV) = sum of discounted FCFs − initial investment. Step-by-step