The Discounted Cash Flow (DCF) analysis is one of the most widely used methods in corporate valuation. It estimates the intrinsic value of a company by projecting future cash flows and discounting them back to their present value. This approach allows investors and finance professionals to assess a company’s worth based on its underlying business performance and long-term potential rather than its current market price.
Within the broader landscape of valuation models, DCF belongs to the income-based valuation approaches, complementing the market-based methods like trading and transaction multiples and the asset-based approaches such as net asset value.
What Is Discounted Cash Flow Analysis?
Discounted Cash Flow (DCF) analysis is a valuation method. It helps analysts estimate how much an investment or a company is worth today based on how much money it's expected to make in the future. It's widely used in finance, investment banking, and business valuation.
DCF accounts for the fact that money today is worth more than the same amount of money in the future due to:
- Time value of money (opportunity cost)
- Risk and uncertainty
- Inflation
How Does DCF Work?
DCF works in four primary steps:
The total value is then compared to the current market price to assess whether the investment is undervalued or overvalued.
Let’s go over each of these steps in detail below.
1. Forecast Future Cash Flows
The first step in DCF analysis is forecasting the cash a company is expected to generate over a specific period, typically 5 to 10 years. It’s a very important step because the usefulness or accuracy of the valuation is highly sensitive to these projections.
Analysts use historical data, industry trends, and assumptions about future performance. They make assumptions about factors like sales growth, operating margins, and capital expenditures to estimate these future cash flows.
2. Determine a Discount Rate
Once the future cash flow estimates are ready, you’ll need to discount them back to the present day using a discount rate. Applying the right discount rate determines the current worth of those future earnings.
For company valuation, the discount rate is usually the company's weighted average cost of capital (WACC). A firm’s WACC is like the average interest rate it has to pay to everyone who has invested in it (both lenders and shareholders), considering how much money each group has put in.
A higher discount rate lowers the present value of future cash flows, while a lower discount rate increases it. This can significantly influence whether an investment is considered viable.
3. Calculate the Present Value of Future Cash Flows & Terminal Value
The next step is to perform the calculations. Discount each year's forecasted cash flow to its current value using the chosen discount rate. The formula for discounting is:
Where:
- CF₁, CF₂, ... CFₙ represent the projected cash flows in each respective year
- r is the discount rate (e.g., the WACC)
In addition, a terminal value is often calculated to reflect the value of the company beyond the explicit forecast period.
The terminal value can be calculated in two ways:
- Perpetuity Growth Method (Gordon Growth Model):
This method assumes that free cash flows will grow at a constant rate g indefinitely after the final forecast year. The formula is:
Here, CFₙ₊₁ is the cash flow in the year following the last explicit forecast year, r is the discount rate, and g is the assumed long-term growth rate. - Exit Multiple Method:
This method assumes the company is sold at the end of the forecast period for a specific multiple (e.g., EV/EBITDA). The terminal value is then calculated as:
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