Discounted Cash Flow (DCF)

What is DCF?

Discounted Cash Flow (DCF) is a valuation method that estimates the present value of an investment by forecasting its expected future cash flows and discounting them to today using an appropriate discount rate. It is used to assess whether an investment, project, or company will generate returns above its current cost.

Key takeaways

• DCF converts future cash flows into a present value to account for the time value of money.
• The discount rate reflects the required rate of return (companies often use WACC).
• If the DCF (present value of future cash flows) exceeds the current cost, the investment may be attractive.
• DCF is sensitive to assumptions about future cash flows and the discount rate; use it alongside other valuation methods.

How DCF works

1. Forecast the expected future cash flows (operating cash flows, free cash flow to the firm, or dividends, depending on the application).
2. Choose a discount rate that reflects risk and the opportunity cost of capital (for firms, commonly the weighted average cost of capital, WACC).
3. Discount each future cash flow to its present value and sum them. Optionally, add a terminal value to capture cash flows beyond the explicit forecast period.

The time value of money underpins DCF: a dollar today is worth more than a dollar tomorrow because today’s dollar can be invested to earn a return.

DCF formula

DCF (present value) for n periods:
DCF = CF1/(1+r)^1 + CF2/(1+r)^2 + ... + CFn/(1+r)^n
where:
* CFt = cash flow in year t
* r = discount rate

Terminal value (for cash flows beyond year n) is commonly estimated using a perpetuity formula:
Terminal Value = CFn+1 / (r - g)
where g is the long-term growth rate.

Example calculations

1) Simple 3-year example
Assume cash flows of $100 at the end of each of the next 3 years and a discount rate of 10%:
* Year 1 PV = 100 / 1.10 = 90.91
Year 2 PV = 100 / 1.10^2 = 82.64
Year 3 PV = 100 / 1.10^3 = 75.13
Total DCF = 90.91 + 82.64 + 75.13 = $248.68

2) Project evaluation with initial cost
If an investment costs $200 and its DCF (present value of future cash flows) is $248.68, the net present value (NPV) = 248.68 − 200 = $48.68 (a positive NPV indicates value creation).

3) Company project example (summary)
A company uses WACC = 5% as the discount rate. If the discounted sum of projected cash flows for a five-year project equals $13,306,727 and the initial investment is $11,000,000, then:
* NPV = 13,306,727 − 11,000,000 = $2,306,727 (positive, so the project could be worthwhile).

DCF vs. NPV

DCF is the present value of all expected future cash flows. NPV takes the DCF and subtracts the initial (upfront) investment:
* NPV = DCF − Initial Investment
A positive NPV implies the project should generate returns above the discount rate; a negative NPV suggests it does not.

Advantages

• Provides a direct estimate of intrinsic value based on cash generation.
• Applicable to many types of investments and projects.
• Flexible — allows scenario analysis and sensitivity testing.

Disadvantages and limitations

• Heavily dependent on forecasts and assumptions (cash flows, discount rate, growth rates).
• Small changes in inputs can produce large changes in value.
• Does not capture all qualitative risks (market shifts, technological disruption) and should not be the sole decision tool.

How to perform a DCF (practical steps)

1. Forecast cash flows for an explicit forecast period (typically 3–10 years).
2. Estimate a terminal value for cash flows beyond the forecast period.
3. Select an appropriate discount rate (e.g., WACC for firm-level analysis).
4. Discount each cash flow and the terminal value to present value.
5. Sum discounted values to get DCF; subtract initial investment to obtain NPV if evaluating a project.

Conclusion

DCF is a foundational valuation tool that translates expected future cash flows into a present value, helping investors and managers evaluate investment decisions. Its usefulness depends on the quality of the underlying cash-flow forecasts and the reasonableness of the chosen discount rate. Use DCF alongside other valuation methods and sensitivity analysis to make more robust decisions.