Discounted Cash Flow Basics
A discounted cash flow (DCF) valuation estimates what a business is worth today by projecting the free cash flow it is expected to produce and discounting that cash back to present value. The result depends heavily on the assumptions about growth and risk.
Projecting free cash flow. Free cash flow is the cash a business generates after paying its operating costs, taxes and the investments needed to keep the business running and growing. It is the cash that could, in principle, be paid out to the investors who fund the company.
A DCF starts by forecasting this cash for a series of future years. The forecast usually begins with a growth assumption for revenue and then carries it through to cash. A higher growth rate raises each later year's cash flow, and the effect compounds over time. Because the forecast cannot run forever, a DCF typically adds a terminal value, an estimate of the business's worth beyond the last forecast year, so that the cash after that point is not ignored.
Discounting to present value. Money received later is worth less than the same money today, because cash in hand can be invested and because future cash is uncertain. Discounting turns a future amount into its present value by dividing it by (1 + r) raised to the number of years, where r is the discount rate.
For example, with a discount rate of 10%, 110 received one year from now has a present value of 100, since 110 divided by 1.10 is 100. Cash two years away is divided by 1.10 twice, so it shrinks more. The DCF value is the sum of the present values of every projected cash flow plus the present value of the terminal value.
How growth and risk assumptions move the result. Growth and risk enter the model in different places. Growth sits in the cash flow forecast: a higher growth rate lifts the projected cash and raises the value. Risk sits in the discount rate: the riskier the cash flows are judged to be, the higher the rate, and the more heavily every future dollar is discounted, which lowers the value.
The two effects can pull against each other. Because the terminal value is often a large share of the total and depends on both the long-run growth rate and the discount rate, small changes to either can shift the result a great deal. This is why a DCF result is read as a product of its assumptions, not as a single fixed answer.
