What Is Discounted Cash Flow? How to Value Investments and Companies

Key takeaways

Discounted cash flow (DCF) is a financial technique that estimates the present value of future cash flows using an appropriate discount rate.

• The basic DCF formula calculates the present value as the future cash flow value divided by one plus the discount rate to the “n” power, where n is the number of periods until the projected cash flow.

• DCF analysis relies heavily on assumptions related to market conditions, competitors, changing regulatory landscapes, and future organizational performance.

• You can determine your discount rate by using financial analytics and metrics such as the weighted average cost of capital (WACC) or the capital asset pricing model (CAPM), depending on your goals.

Learn more about what a discounted cash flow analysis is, how to implement one yourself, and how it compares to other financial measures. Or, start learning by completing the IBM Business Intelligence (BI) Analyst Professional Certificate. In as little as four months, you can build skills in SQL queries, relational databases, data gathering and cleaning, data warehousing, data analysis, and reporting techniques. By the end, you’ll have a shareable certificate to add to your professional profile. 

What is discounted cash flow?

Discounted cash flow (DCF) is a method you can use to value investments by discounting the estimated future cash flows. This means that the future cash flow estimate adjusts downward to reflect what the value would be worth in today’s dollars. 

To calculate the DCF, determine the discount rate, the number of periods, and the cash flow for each period. Then plug these into the following formula:

DCF= CF1/(1+r)^1 + CFn/(1+r)^n

r is the discount rate, CF1 is the cash flow for the first period, n is the period number (so 2 for the second period, 3 for the third, etc.), and CFn is the cash flow for that period.

For example, if you expect to receive $5,000 one year from now and apply a 10 percent discount rate, the future amount would have a present value of $4,545.45. The formula would look like this: 

5,000 / (1+.10) ^1 = 4,545.45

For a business use case, suppose you’re comparing two projects to invest in. The first project has a 10 percent discount rate and an estimated return of $1,000,000 over two years ($500,000 per year), yielding a DCF value of $867,769. The second project has a five percent discount rate and an estimated return of $1,000,000 over three years ($333,333 per year), with a DCF value of $907,749. According to your DCF analysis, the second project may be more profitable.

Using the DCF equation, investors can compare projects with different timelines, risk, and expected cash flows across a more level playing field.

Importance of DCF in finance and investment

DCF is valuable for long-term financial decisions, particularly investment decisions, because it helps you get a clearer picture of the cash flow’s actual value. If you were to simply add up estimated future dollars, this may present an inflated or misleading picture. 

A project that returns $1,000,000 over three years isn’t producing the same value as one that produces $3,000,000 in one year, even though the final totals are the same. Discounting allows investors, analysts, and other corporate finance professionals to convert different potential cash flow streams into comparable values to make more informed investment decisions.

How DCF differs from other valuation methods

In relative valuation methods, you compare a company to peers using valuation metrics like price-to-earnings ratios, rather than taking an intrinsic valuation approach with absolute valuation methods, such as DCF. 

DCF attempts to determine an asset’s value today based solely on its intrinsic value, without comparing it to other organizations in the market. Relative valuations provide insight into whether companies are over- or undervalued based on sales, revenue, market capitalization, and so on. 

While the two types of measures provide different insights into a company’s financial position, using both types of valuation together can give you a more complete view of a company’s worth and investment value.

How discounted cash flow works

Calculating discounted cash flow relies on a few key principles, including the time value of money, forecasting principles, and the discount rate. Examine each in more detail for a clearer understanding of how discounted cash flow works

Time value of money principle

One of the foundational concepts of DCF is that an amount of money now is worth more than the same amount in the future. This goes beyond inflation. If you have money today, you can invest it and earn returns. The discount rate in DCF captures the opportunity cost along with the risk that the promised future cash flows might not materialize exactly as expected. 

Forecasting cash flows

Another important part of DCF calculations is the forecasting component. Analysts can forecast cash flows for a specific period of time, like five or 10 years, making reasonable assumptions about growth and margins. To make an accurate forecast for your DCF model, it’s important to understand the business model, competitive dynamics, and industry trends.

Learn more: Market Analysis: What It Is and How to Conduct One 

Choosing the discount rate

Selecting the appropriate discount rate is a critical step in determining the final present-day value. One of the most common ways to determine a discount rate is to use the WACC, which is the combined cost of debt and equity financing. If you’re doing an equity-focused valuation, you might choose to use the cost of equity alone, often estimated using the CAPM. The rate set should match the riskiness of the cash flows being discounted, with higher-risk ventures correlated to higher discount rates.

Calculating the present value: What is a simple discounted cash flow formula?

The basic DCF formula is: Present value = Future cash flow / (1 + discount rate)^n

In this formula, “n” represents the number of periods until the cash flow occurs. If you have multiple cash flows, you can calculate the present value of each one and sum them. For example, if you expect to receive $100 in year one, $200 in year two, and $300 in year three, each with a 10 percent discount rate, the formula would be:

Present value = $100 / (1.10)^1 + $200 / (1.10)^2 + $300 / (1.10)^3 = $481.59

Types of discounted cash flow analysis

You can calculate your discounted cash flow using several different methods. What you choose depends largely on whether you want to represent the total enterprise value or focus on shareholder returns. 

Free cash flow to the firm (FCFF)

Free cash flow to the firm represents the total cash available. This is typically valued after accounting for operating expenses, taxes, and capital expenditures. The discount rate used in this model is often the WACC, and the final valuation represents the company’s total enterprise value. 

Free cash flow to equity (FCFE)

Free cash flow to equity measures the total cash that could be given to common shareholders after the organization meets all obligations to debt holders. The FCFE starts with net income, then adds back non-cash charges, removes capital expenditures, and adjusts for borrowing activity. In this case, the cost of equity is the discount rate, and the resulting valuation is the equity value.

Variations and adjustments in practice

In real-world scenarios, it’s not uncommon to modify standard DCF approaches. For example, adjusted present value (APV) methods separate the value of operations from the value of financing decisions, like debt financing, which may better suit companies with changing debt levels or complex financial arrangements. In some cases, professionals might use multiple scenarios with probability weightings to address uncertainty, such as Monte Carlo simulations. 

Advantages and limitations of using a discounted cash flow model

DCF offers several advantages over alternative valuation approaches, including a clear representation of the assumptions about growth, profitability, and risk in the model. It also offers a high level of flexibility, enabling you to apply it to a wide range of companies and organizations to estimate value. If you want to consider several projections, you can create different scenarios and compare the estimated cash flows in each, allowing you to see how returns would change under different market conditions. 

While offering several advantages, DCF has inherent limitations that are important to consider to gain a full view of the company. While transparent, DCF requires assumptions to forecast future performance, making it sensitive to estimates that may not be right. To make a realistic estimate, you need to understand market demand and the current economy. You should also consider the future economy, predicted technological advances, competition, and possible unexpected problems. Using this valuation method alongside others may help to reduce risk and allow you to make informed financial decisions.

Key considerations when performing DCF

The reliability of your DCF valuation depends on the quality of your underlying assumptions. When designing your model, a few of the following considerations to keep in mind include:

• Forecast accuracy: Ground your forecasts in predictive analytics, historical growth, and industry dynamics to create a realistic prediction. 

• Assumption accuracy: Carefully consider assumptions about revenue growth, operating margins, the WACC, and your organization's terminal value to build the most accurate model.

• Market condition analyses: Consider economic cycles and the potential risks to your cash flow. Think about regulatory changes, technology disruption, and competitive threats, and how these may influence your organization. 

• Sensitivity analyses: Consider different input values and how they affect your final value. You can compare different discount rates and growth rates to see how your assumptions influence potential final values. 

Real-world applications of DCF

You can find DCF used across financial and investment sectors to value companies, determine investment risk, and estimate the future value of new companies. While these valuations use the same principles, they serve different purposes.

Valuing companies for mergers and acquisitions

For mergers and acquisitions, DCF analysis helps the buyer determine what price they should pay for their target company. The buyer can project the standalone cash flows and establish a ceiling price that ensures the deal creates value for their shareholders. The seller can also use DCF to assess their company's value and negotiate based on that assessment.

Investment decisions and capital budgeting

When evaluating capital investments, such as new businesses or expansions of existing businesses, corporations can use DCF to project cash inflows and outflows and assess how the new venture may affect shareholder value, after adjusting for risk. If the organization wants to consider several competing projects, DCF can help determine which is the most profitable. 

Start-up and project evaluation

Venture capitalists and private equity investors apply DCF concepts to value start-ups and growth-stage companies to determine whether it might be a smart investment. However, in this scenario, future cash flow is typically highly uncertain, leading to more unreliable assumptions and estimates that may use higher discount rates to account for risk.

Is DCF the same as NPV?

While closely related, the DCF and net present value (NPV) of a company are not the same. DCF is the broader financial technique used to determine the present value of estimated future cash flow value, while NPV is the net value created by subtracting the initial investment from the sum of the discounted cash flows. NPV essentially answers whether an investment’s future cash flows exceed the cost, suggesting it may be a profitable choice.

Tools and resources for DCF analysis

To conduct your own DCF analysis, you can take advantage of several tools and resources to customize your assumptions and structure based on your organization. A few to start with include: 

• Spreadsheet models: You can build DCF models in Excel or other spreadsheet software to organize your data and input calculations. 

• Financial software and platforms: You can leverage tools like Bloomberg Terminal or online DCF calculators to utilize existing financial data and platforms to build your analytics model.

• Learning resources and certifications: Taking online courses, bootcamps, or financial analysis certificate programs can help you build analytics skills. Courses in corporate finance or business analytics may help you build a foundation for more advanced courses tailored to your interests.

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