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  5. Discounted Cash Flow

Discounted Cash Flow

A valuation method that estimates the present value of a company or investment by discounting projected future cash flows at an appropriate rate.

Financial ReportingInvestment Management

FAQs

What discount rate should I use in a DCF?

For a business, use the Weighted Average Cost of Capital (WACC) — the blended cost of equity and debt financing. For equity-only analysis, use the cost of equity (CAPM-derived: risk-free rate + beta × equity risk premium). For project analysis, use the project's required return based on its specific risk. WACC for established US companies typically ranges from 8–12%; startups may use 15–25% to reflect higher risk.

What is sensitivity analysis in DCF?

Sensitivity analysis tests how DCF value changes with different assumptions — typically shown as a two-variable data table varying discount rate and terminal growth rate (or discount rate and near-term growth rate). Because DCF value is highly sensitive to these inputs, sensitivity tables show the range of plausible values rather than a single point estimate. A result showing value from $50–$100/share is more informative than a false-precision $74/share.

Why is terminal value so important in DCF?

Terminal value captures all cash flows beyond the explicit forecast period (typically 5–10 years). For most companies with indefinite operating lives, this represents 60–80% of total DCF value. The terminal value is extremely sensitive to the perpetuity growth rate assumption — changing it by 0.5% can change total value by 20–30%. This is why DCF results for growth companies are more art than science and must be accompanied by sensitivity analysis.

Related Terms

Weighted Average Cost of Capital

The blended rate of return required by all of a company's capital providers — debt and equity — weighted by their proportions, used as the discount rate in valuation.

Enterprise Value

The total value of a company available to all capital providers — equity holders and debt holders — used as a basis for acquisition pricing and valuation multiples.

LBO Model

Financial model analyzing private equity returns from a leveraged buyout at various exit scenarios.

Three-Statement Model

Integrated financial model linking the income statement, balance sheet, and cash flow statement.

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Discounted Cash Flow (DCF) analysis is a fundamental valuation methodology that estimates the intrinsic value of a business, project, or investment by calculating the present value of expected future cash flows, discounted at a rate reflecting the time value of money and investment risk (the Weighted Average Cost of Capital, or appropriate discount rate).

The core principle: a dollar received in the future is worth less than a dollar received today (time value of money). Discounting converts future cash flows to their equivalent value in today's dollars, allowing comparison to the current investment cost.

DCF Value = Σ (Cash Flow_t ÷ (1 + r)^t) for all periods t = 1 to n, plus Terminal Value ÷ (1 + r)^n

For example, if a business generates $1M in free cash flow this year, growing at 10% annually for 5 years then 3% in perpetuity, discounted at 10% WACC, the DCF yields a specific intrinsic value. The Terminal Value (representing cash flows beyond the explicit forecast period) typically represents 60–80% of total DCF value — making the terminal growth rate assumption enormously impactful.

DCF advantages: it's theoretically rigorous, forcing explicit assumptions about growth, margins, and risk. It anchors valuation in cash generation, not accounting metrics. It's flexible — applicable to companies, projects, real estate, bonds, and any cash-generating asset.

DCF limitations: 'garbage in, garbage out' — small changes in growth rate, discount rate, or terminal assumptions produce wildly different values. For early-stage companies with uncertain cash flows, DCF is unreliable. The terminal value dominates results, making long-term assumptions disproportionately impactful.

Practical DCF applications: corporate M&A (is the target worth the asking price?), capital budgeting (is this $10M investment worth more than it costs?), and investment analysis (is this stock trading above or below intrinsic value?).