What you will learn
- State the central idea of a discounted cash flow valuation
- Explain why future cash flows must be discounted before adding them up
- Discount a single future cash flow to its present value
- Name the three ingredients of a DCF and the strength and weakness of the method
If intrinsic value is what a business is worth, the discounted cash flow model, or DCF, is the most direct attempt to calculate it. It ties together two things you already learned: the time value of money from Unit 1 and free cash flow from Unit 2. If those two ideas are solid, the DCF will feel natural.
The DCF model explained (The Plain Bagel)
A jargon-light overview of how professionals value businesses by discounting future cash flows. The best starting point for this whole unit.
The central idea
A business is worth the total cash it will hand its owners over its entire future life, with each future dollar adjusted for the fact that money later is worth less than money now. That is the whole concept. A company is not worth what it owns today or what it earned last year. It is worth the stream of cash it can produce going forward, valued in today's terms.
Why we discount
Recall the time value of money. A dollar arriving in five years is worth less than a dollar in your hand today, because today's dollar can be invested and grown, because inflation eats future purchasing power, and because the future is uncertain. So we cannot simply add up future cash flows. We must discount each one back to its present value first, using a discount rate that reflects both the opportunity cost of your money and the riskiness of the cash flows.
Key terms
- Discounted cash flow (DCF)
- A valuation that adds up a company's future cash flows, each discounted back to today.
- Free cash flow
- The cash a business generates after paying its costs and making necessary investments. The cash flow a DCF projects.
- Discount rate
- The rate used to shrink future cash flows to present value. It reflects risk and opportunity cost.
- Terminal value
- The value of all cash flows beyond the explicit forecast period, since companies keep operating.
Discounting one future cash flow
A business will hand you 121 dollars two years from now. If the right discount rate is 10 percent, what is that future cash worth today?
- Use the present value idea. Present value equals the future amount divided by one plus the rate, raised to the number of years.
- Plug in. 121 divided by 1.10 to the power of 2, which is 121 divided by 1.21.
- Solve. That equals 100 dollars.
Why it matters: A DCF does exactly this to every future year's cash flow, then adds up all the present values. That total is the estimate of what the business is worth.
Discount a cash flow to today
A company will produce 110 dollars of free cash flow one year from now. Using a discount rate of 10 percent, what is that worth in today's dollars?
A business is worth the present value of the cash it will hand its owners for the rest of its life. Everything else is detail.
The three ingredients
- Projected future cash flows: an estimate of the free cash flow the business will generate over an explicit forecast period, usually five to ten years.
- A discount rate: the rate that converts those future cash flows into present value, reflecting risk and opportunity cost. For the whole firm this is usually the weighted average cost of capital.
- A terminal value: an estimate of the value of all cash flows beyond the explicit forecast period, since companies are assumed to keep operating indefinitely.
Each of these three ingredients gets its own lesson in this unit, because each one involves real judgment. Once you have all three, the mechanics are simple: discount the projected cash flows and the terminal value back to today, add them up, and you have an estimate of what the business is worth.
Match each ingredient to its job
Pair each of the three DCF ingredients with what it represents.
The great strength and the great weakness
The DCF is the most theoretically sound valuation method, because it values a company on what truly matters, its ability to generate cash, rather than on what other people happen to be paying for similar companies. That is its strength. Its weakness is the flip side of the same coin. The answer is only as good as the assumptions feeding it. Small changes in the growth rate or the discount rate can swing the result enormously. Practitioners call this garbage in, garbage out. A DCF does not remove judgment. It organizes it, and it makes your assumptions explicit so they can be challenged.
Discounted cash flow (DCF) model explained (Corporate Finance Institute)
A clean second pass on the DCF structure. Watch for how the three ingredients fit together into one valuation.
Garbage in, garbage out
Two analysts build a DCF on the same company. One assumes 4 percent growth, the other assumes 20 percent growth for a decade, and they get wildly different values. What does this show about the DCF?
A DCF is only as good as its inputs. Reasonable people can get very different answers from different assumptions, which is why the assumptions, not the arithmetic, are where the real work lies.You have the big picture of a DCF. The next three lessons take its ingredients one at a time, starting with the hardest and most important: estimating the future cash flows.