Discounted Cash Flow (DCF)

Valuation Model Investment Wiki — Fundamentals
Discounted Cash Flow (DCF) analysis is an absolute valuation method used to estimate the intrinsic value of an investment based on its expected future cash flows. It rests on the foundational financial principle that the value of any asset is the present value of all the cash it will ever generate, discounted back to today at an appropriate rate of return to account for time value and risk.
Quick Reference
Type Valuation Model
Core Equation Intrinsic Value = ∑ (FCFt / (1 + r)t) + Terminal Value
Discount Rate Weighted Average Cost of Capital (WACC)
Target Output Intrinsic Value > Market Price = Undervalued
Best Used For Companies with predictable, stable cash flows

1.0 The Formula

Basic Form

formulaDCF = (CF1 / (1+r)^1) + (CF2 / (1+r)^2) + ... + (CFn / (1+r)^n) + TV

Where:
CF = Expected Free Cash Flow for a given year
r = Discount rate (usually WACC)
n = Time period in years
TV = Terminal Value (the value of the business beyond the forecast period)

The DCF model projects free cash flows (FCF) for a specific horizon (usually 5 to 10 years). Because cash generated 10 years from now is worth less than cash today, each year's cash flow is divided by a discount factor (1 + r)^t. Finally, a Terminal Value is calculated to estimate the perpetual value of the business past the explicit forecast period.

Worked Example

Year Projected FCF Discount Factor (10%) Present Value (PV)
Year 1 $100M 1.10 $90.9M
Year 2 $110M 1.21 $90.9M
Year 3 $121M 1.33 $90.9M
Terminal Value $1,500M 1.33 $1,126.9M
Total Enterprise Value $1,399.6M

In this simple 3-year model with a 10% discount rate, the total present value of the cash flows plus the terminal value is approximately $1.4 Billion. If the company has NO debt and 100 million shares outstanding, the intrinsic value per share is $14.00. If the stock trades at $10.00, it is theoretically undervalued by 40%.

The Terminal Value usually accounts for 60% to 80% of a DCF's total valuation. Because it relies heavily on assumption (the perpetual growth rate), the terminal value is the most sensitive and heavily scrutinized part of a DCF.

2.0 Interpretation & Edge Cases

Interpreting the Output

A DCF yields an "Intrinsic Price Target." Investors compare this target to the current market price:

  • Intrinsic Value > Current Price (e.g., $50 vs $30): The stock is undervalued. Investors typically look for a "margin of safety" of 20-30% below intrinsic value before buying.
  • Intrinsic Value = Current Price: The stock is fairly valued. You will exactly earn the discount rate if holding the stock.
  • Intrinsic Value < Current Price: The stock is overvalued.

When it Fails (Pitfalls)

A DCF is only as good as its inputs ("Garbage in, garbage out"). Minor changes to the discount rate or terminal growth rate can wildly alter the output.

DCF analysis is terrible for early-stage startups, highly cyclical companies (like commodity miners), or distressed companies, because projecting precise cash flows 5 years out for these businesses is practically impossible. Use DCF for mature, cash-generating businesses.

3.0 Related Pages

Free Cash Flow (FCF)

The "CF" in DCF. You must correctly calculate free cash flow before you can discount it.

Weighted Average Cost of Capital (WACC)

The standard discount rate used in a DCF model to bridge the gap between present and future value.

Portfolio Allocation

A high margin of safety (determined via DCF) justifies a heavier weighting in an investment portfolio.