Discounted Cash Flow (DCF): Definition, Formula, and Example
Discounted Cash Flow (DCF) is a valuation method that estimates the value of a company, project, or investment by converting its expected future free cash flows into today’s dollars using a discount rate. The core idea: money today is worth more than the same amount in the future due to risk and the time value of money.
When to Use DCF
- Businesses with reasonably forecastable cash flows (mature SaaS, manufacturing, utilities).
- Project appraisal and capital budgeting (compare to hurdle rate/WACC).
- Equity valuation in investment banking, private equity, and corporate finance.
Not ideal for: banks/financials (cash flow definitions are different), very early-stage startups, or highly cyclical firms with unpredictable cash flows—alternative models (Dividend Discount, Residual/Excess Returns, or comparables) are often preferred.
DCF Formula (Present Value of Free Cash Flows)
For n forecast years with a terminal value at year n:
DCF (Enterprise Value) = Σ [ FCFₜ / (1 + r)ᵗ ] (t = 1…n) + TV / (1 + r)ⁿ- FCF = Unlevered free cash flow (to the firm).
- r = Discount rate, typically WACC (Weighted Average Cost of Capital).
- TV = Terminal Value (via perpetual growth or exit multiple).
Unlevered Free Cash Flow (common definition)
FCF = EBIT × (1 – Tax Rate) + D&A – Capex – ΔNWCWACC (typical discount rate)
WACC = (E/(D+E)) × Rₑ + (D/(D+E)) × Rd × (1 – Tax Rate)- Rₑ (cost of equity) often via CAPM: Rf + β × (Market Premium) (+ adjustments as needed).
- Rd = pre-tax cost of debt; tax shield reduces it by (1 – Tax Rate).
Terminal Value (two common methods)
- Perpetual Growth:
TV = FCFₙ₊₁ / (WACC – g)whereFCFₙ₊₁ = FCFₙ × (1 + g)andgis long-term growth. - Exit Multiple: Apply a market multiple (e.g., EV/EBITDA) to year-n metric.
Worked Example (5-year DCF)
Assume five years of unlevered FCF (in $mm): 10, 12, 14, 15, 16. Use WACC = 9% and perpetual growth g = 3%.
- PV of discrete FCFs: Discount each FCF at 9% back to today.
- Terminal Value at Year 5: FCF₆ = 16 × (1 + 0.03) = 16.48 → TV = 16.48 / (0.09 – 0.03) ≈ 274.67.
- PV of TV: Discount TV by (1.09)⁵ ≈ 1.5386 → PV(TV) ≈ 178.51.
- Enterprise Value: PV(FCFs) ≈ 51.11 + PV(TV) ≈ 178.51 → EV ≈ 229.62.
- Equity Value: EV – Net Debt (e.g., 30) ≈ 199.62. If 50 mm shares → ≈ $4.00/share.
Note: Small changes in WACC, growth, or FCF assumptions can materially change the result—always run sensitivities.
DCF vs. NPV, IRR, and WACC
- DCF vs. NPV: DCF is the process; NPV is the numeric result after subtracting the initial investment.
- DCF vs. IRR: IRR is the discount rate that sets NPV to zero. DCF uses a chosen rate (often WACC) to compute present value.
- Is WACC the same as DCF? No. WACC is an input (the discount rate). DCF is the valuation model.
Why Analysts Use DCF
- Fundamental, cash-based: Values the business on its ability to generate free cash.
- Flexible: Can incorporate detailed operating drivers, scenarios, and sensitivities.
- Complements multiples: Serves as a cross-check against trading/transaction comps.
Common Drawbacks & Pitfalls
- Assumption sensitivity: Small shifts in growth, margins, Capex, or WACC can swing value.
- Terminal value dominance: TV often represents a large share of EV—stress-test g and exit multiples.
- Forecast risk: Overly optimistic cash flows or ignoring working-capital needs inflates value.
- Capital structure drift: Misaligning WACC with the forecast period or target leverage skews results.
FAQ (Quick Answers)
- What is DCF in simple terms? Turning future cash flows into today’s value using a discount rate.
- Is DCF the same as NPV? NPV is the output of a DCF after subtracting the initial investment.
- How do you calculate DCF? Forecast FCF, pick WACC, discount FCFs and terminal value, sum to EV.
- Biggest drawback? High sensitivity to assumptions (WACC, growth, terminal value).
- Is DCF the same as IRR? No—IRR is the break-even discount rate; DCF uses an assumed rate.
- Why not for banks? Deposit-funded models and regulatory capital make traditional FCF less meaningful; use Dividend/Residual models.
- Is DCF based on EBITDA? Indirectly—start from EBIT/EBITDA but adjust to free cash flow (taxes, Capex, ΔNWC).
- Is WACC the same as DCF? WACC is the discount rate; DCF is the valuation framework.
Related Terms
Valuation model, free cash flow (FCF), WACC, NPV, IRR, terminal value, exit multiple, equity value, enterprise value, sensitivity analysis, investment banking.
FAQs Discounted Cash Flow
Discounted Cash Flow (DCF) is a method used to estimate the value of an investment or business by calculating the present value of expected future cash flows. It answers the question: "How much are future profits worth today?"
Not exactly. Net Present Value (NPV) is the outcome of a DCF calculation. DCF is the process, while NPV is the result after subtracting the initial investment.
The formula is:
DCF = CF₁ / (1+r)¹ + CF₂ / (1+r)² + … + CFₙ / (1+r)ⁿ
Where CF = Cash Flow, r = Discount Rate (often WACC), and n = time period.
DCF is widely used in corporate finance, equity research, and investment banking because it values a company or asset based on fundamentals rather than market sentiment.
Its accuracy depends heavily on assumptions: future cash flow projections, discount rates, and terminal value. Small changes can significantly alter the valuation.
No. The Internal Rate of Return (IRR) is the discount rate that makes the NPV of all future cash flows equal to zero. DCF uses a chosen discount rate to compute present value.
Banks are highly regulated, rely on deposits rather than free cash flow, and their capital structures make it difficult to apply traditional DCF. Instead, analysts use Price-to-Book or Dividend Discount Models.
Not directly. DCF typically uses Free Cash Flow (FCF), which adjusts EBITDA by subtracting taxes, changes in working capital, and capital expenditures.
No. WACC (Weighted Average Cost of Capital) is the discount rate often used in a DCF calculation. DCF is the valuation model; WACC is one of its inputs.
