Basic, lesson 1 of 4
The idea of a DCF
A business is worth the cash it will produce, adjusted for when it arrives and how risky it is. A DCF is that sentence turned into arithmetic.
7 min, 3 checks
1Money later is worth less than money now
A dollar today can be invested. A dollar promised next year cannot, and it might not show up. So a promise of future cash is worth less than the same amount in hand, and the gap grows the further out and the riskier the promise.
The discount rate captures both effects in one number. If you could earn 10% elsewhere on something equally risky, then $100 one year from now is worth whatever amount grows to $100 at 10%. That amount is the present value.
Present value = Cash flow / (1 + r) ^ t
r is the discount rate per year, t is the number of years until the cash arrives.
Worked example
Three years of cash at 10%
- 1Year 1: $100 / 1.10 = $90.91
- 2Year 2: $110 / 1.10^2 = $110 / 1.21 = $90.91
- 3Year 3: $121 / 1.10^3 = $121 / 1.331 = $90.91
- 4Add them: $90.91 x 3 = $272.73
The three payments total $331 in raw dollars but are worth $272.73 today. Each one happens to grow at exactly the discount rate, which is why every year's present value is the same.
Check 1
What is the present value of $1,000 received in three years at an 8% discount rate?
2From one payment to a whole company
A company is a long stream of future cash flows. A DCF projects that stream for a few years in detail, usually five to ten, then summarizes everything after that in a single terminal value. Each piece is discounted back to today and the pieces are added.
- Project free cash flow for each year of the forecast.
- Pick a discount rate that matches who the cash belongs to and how risky it is.
- Estimate a terminal value for all the years after the forecast.
- Discount every cash flow and the terminal value to today and add them up.
- Move from that total to a value per share.
If the cash flows belong to everyone who funded the company, debt and equity together, the sum is enterprise value. That is the standard banking DCF, and it is what the rest of this track builds.
Check 2
Holding the cash flows fixed, what happens to a DCF value when the discount rate goes up?
3Why bankers use it, and why they distrust it
A DCF is the only common method that values the business on its own cash rather than on what similar companies trade for. That makes it the theoretical anchor. It also makes it fragile: small changes in the discount rate or the long term growth rate swing the answer a lot, and most of the value usually sits in the terminal value, years beyond any real forecast.
So in practice a DCF is one bar on the football field next to comps and precedents. Bankers trust it most for stable, cash generating businesses and least for early companies with negative cash flow today.
Check 3
For which company is a DCF least useful?
Terms in this lesson: Discounted cash flow, Terminal value, Enterprise value, Football field, Comparable companies analysis, Precedent transactions.
3 checks in this lesson. Sign in to keep your progress.