What is DCF (Discounted Cash Flow)?
DCF is a valuation method used to estimate the intrinsic value of an asset (like a stock, a company, or a project) by forecasting its future cash flows and discounting them back to today’s value.
Why discount cash flows?
Because money today is worth more than money in the future (due to inflation, risk, and opportunity cost). DCF helps you figure out how much those future cash flows are worth today.
🏗️ How DCF Works (Step-by-Step)
1️⃣ Estimate Future Cash Flows
Predict the cash flows (e.g., revenue – costs) the asset will generate each year for a certain period (say, 5–10 years).
Example for a business:
-
Year 1: $100,000
-
Year 2: $120,000
-
Year 3: $150,000
…and so on.
2️⃣ Choose a Discount Rate (r)
This reflects the risk and opportunity cost. It’s often based on the Weighted Average Cost of Capital (WACC) or your required rate of return.
3️⃣ Discount Future Cash Flows to Present Value
The formula for discounting each year’s cash flow (CF) is:
Where:
-
CF = Cash Flow in year n
-
r = Discount rate (as decimal, e.g., 10% → 0.10)
-
n = Year number
4️⃣ Calculate Terminal Value
For cash flows beyond the forecast period, we estimate a Terminal Value (TV) using the Gordon Growth Model:
Where:
-
g = Long-term growth rate of cash flows
5️⃣ Sum All Present Values
The total DCF valuation is the sum of:
-
Present value of all forecast cash flows
-
Present value of terminal value
Final DCF formula:
🎓 Example: Simple DCF Calculation
Let’s say:
-
Cash flows for 3 years: $100K, $120K, $140K
-
Discount rate (r) = 10%
-
Terminal growth rate (g) = 3%
Step 1: Discount cash flows
Year 1 PV = 100K / (1+0.10)¹ = $90,909
Year 2 PV = 120K / (1+0.10)² = $99,174
Year 3 PV = 140K / (1+0.10)³ = $105,189
Step 2: Terminal Value
Terminal Value at end of Year 3:
Discounted Terminal Value:
Step 3: Total DCF Value
🔑 DCF Key Takeaways
✅ DCF = What an investment is worth today based on future cash flows
✅ Relies on assumptions: cash flow estimates, discount rate, growth rate
✅ Great for valuing businesses, stocks, projects, real estate
