Discounted cash flow (DCF) analysis estimates the value of an investment based on its expected future cash flows, discounted back to the present. It is the leading intrinsic valuation method: it values a company on its own forecast fundamentals rather than by comparison to others.

The core idea

A dollar received in the future is worth less than a dollar today. DCF makes this explicit by discounting each year's projected cash flow at a rate that reflects the time value of money and risk:

Present value = Σ [ CF_t ÷ (1 + r)^t ] + Terminal value ÷ (1 + r)^n

where CF_t is the cash flow in year t and r is the discount rate.

Steps in a DCF

  1. Project free cash flows. For an enterprise (unlevered) DCF, forecast unlevered free cash flow over an explicit horizon, usually 5–10 years: Unlevered FCF = EBIT × (1 − tax rate) + D&A − capital expenditure − increase in net working capital.
  2. Choose a discount rate. Unlevered cash flows are discounted at the weighted average cost of capital (WACC) — the blended after-tax cost of the firm's debt and equity. The cost of equity is commonly estimated with the capital asset pricing model (CAPM).
  3. Estimate terminal value. Most of a company's value lies beyond the forecast window. Terminal value is estimated either by the Gordon (perpetuity) growth method — FCF × (1 + g) / (WACC − g) — or by applying an exit multiple (e.g. EV/EBITDA) to the final year.
  4. Discount and sum. Discount the explicit cash flows and the terminal value to today and add them to get enterprise value.
  5. Bridge to equity. Subtract net debt and other claims to reach equity value, then divide by shares for a per-share value.

Strengths and weaknesses

Strengths: grounded in fundamentals; not distorted by temporary market sentiment; transparent about assumptions; ideal for incorporating synergies explicitly.

Weaknesses: highly sensitive to inputs — small changes in WACC or the growth rate move the answer a lot. The terminal value frequently accounts for the majority (often 60–80%) of total value, so the method is sometimes criticised as "garbage in, garbage out". Analysts therefore present sensitivity tables across a range of discount rates and growth rates rather than a single point estimate.

Use in M&A

In a deal, a buyer often builds a DCF of the target both standalone and with synergies to judge how much premium is justified. The DCF is then placed alongside trading and transaction multiples on the football field.

See also

  • Business valuation — The set of methods used to estimate the economic value of a company or its equity.
  • Enterprise value — The total value of a company’s operations, independent of its capital structure.
  • Comparable company analysis — Relative valuation using the market multiples of similar publicly traded companies.
  • Precedent transaction analysis — Relative valuation using the multiples paid in comparable past acquisitions.
  • Synergy — The extra value a combined company can create beyond the sum of the two firms apart.

External resources

Practitioner guides from Main Street Wealth, an M&A advisory firm:

References & further reading

  1. Investopedia — “Discounted Cash Flow (DCF)”
  2. Corporate Finance Institute — “DCF Model Training”
  3. Wall Street Prep — “DCF Model Guide”
Category: Valuation