Discounted cash flow
What is Discounted cash flow?
Discounted cash flow valuation estimates value by forecasting future cash flows and discounting them to the present at rates consistent with their risk and timing. Every forecast, discount rate, and terminal assumption must share a coherent currency and inflation basis.
Core DCF approaches
Enterprise DCF discounts free cash flow to the firm at WACC and then bridges enterprise value to equity. Equity DCF discounts cash flow available to common equity at the cost of equity. Dividend models discount dividends. Cash flows, discount rate, inflation basis, currency, and capital claim must remain internally consistent.
How it is calculated
Forecast revenue, margins, taxes, reinvestment, and cash flow for an explicit period. Estimate value beyond that period using a defensible terminal method. Discount each amount to the valuation date, add non-operating assets, subtract debt and other claims as appropriate, and divide equity value by diluted shares. Scenario and sensitivity analysis are essential.
Example
A company is forecast to generate increasing FCFF for five years and then enter stable growth. Those cash flows and terminal value are discounted at WACC to enterprise value. Cash is added and debt, preferred claims, and non-controlling interests are subtracted. The resulting common equity value is divided by fully diluted shares to estimate value per share.
How to interpret it
DCF value is conditional on assumptions, not an observed fact. Identify which variables drive the range, including margin, growth, reinvestment, WACC, and terminal economics. Compare implied forecasts with historical performance, industry structure, and market expectations. A difference from price is meaningful only when supported by a coherent thesis and adequate margin of safety.
Limitations
Small changes in long-term growth or discount rate can materially change value, especially when terminal value dominates. Forecasts can exhibit false precision and omit dilution, liabilities, cyclicality, or disruption. DCF does not eliminate uncertainty; it organizes it. Using a market multiple as terminal value also introduces relative valuation into an intrinsic framework.
Practical checklist
Reconcile historical statements, define FCFF or FCFE, match nominal or real currency assumptions, and make reinvestment consistent with growth. Publish enterprise-to-equity bridge, dilution, terminal share, and sensitivities. Test scenarios and reverse-engineer market expectations. Cross-check with multiples while keeping the independent logic of each method clear.
Also known as: DCF valuation
Sources and further reading
- An Introduction to Valuation, Aswath Damodaran, NYU Stern