Discounted Cash Flow (DCF)


DEFINITION of 'Discounted Cash Flow (DCF)'

Discounted cash flow (DCF) is a valuation method used to estimate the attractiveness of an investment opportunity. DCF analysis uses future free cash flow projections and discounts them to arrive at a present value estimate, which is used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one.

Calculated as:

Discounted Cash Flow (DCF)

DCF is also known as the Discounted Cash Flows Model.


Loading the player...

BREAKING DOWN 'Discounted Cash Flow (DCF)'

There are several variations when it comes to assigning values to cash flows and the discount rate in a DCF analysis. But while the calculations involved are complex, the purpose of DCF analysis is simply to estimate the money an investor would receive from an investment, adjusted for the time value of money

The time value of money is the assumption that a dollar today is worth more than a dollar tomorrow. For example, assuming 5% annual interest, $1.00 in a savings account will be worth $1.05 in a year. Due to the symmetric property (if a=b, then b=a), we must consider $1.05 a year from now to be worth $1.00 today. When it comes to assessing the future value of investments, it is common to use the weighted average cost of capital (WACC) as the discount rate.

For a hypothetical Company X, we would apply DCF analysis by first estimating the firm's future cash flow growth. We would start by determining the company's trailing twelve month (ttm) free cash flow (FCF), equal to that period's operating cash flow minus capital expenditures. Say that Company X's ttm FCF is $50 m. We would compare this figure to previous years' cash flows in order to estimate a rate of growth. It is also important to consider the source of this growth. Are sales increasing? Are costs declining? These factors will inform assessments of the growth rate's sustainability. 

Say that you estimate that Company X's cash flow will grow by 10% in the first two years, then 5% in the following three. After a few years, you may apply a long-term cash flow growth rate, representing an assumption of annual growth from that point on. This value should probably not exceed the long-term growth prospects of the overall economy by too much; we will say that Company X's is 3%. You will then calculate a WACC; say it comes out to 8%. The terminal value, or long-term valuation the company's growth approaches, is calculated using the Gordon Growth Model:

Terminal value = projected cash flow for final year (1 + long-term growth rate) / (discount rate - long-term growth rate)

Now you can estimate the cash flow for each period, including the the terminal value:

Year 1 = 50 * 1.10 55
Year 2 = 55 * 1.10 60.5
Year 3 = 60.5 * 1.05 63.53
Year 4 = 63.53 * 1.05 66.70
Year 5 = 66.70 * 1.05 70.04
Terminal value = 70.04 (1.03) / (0.08 - 0.03) 1,442.75

Finally, to calculate Company X's discounted cash flow, you add each of these projected cash flows, adjusting them for present value using the WACC:

DCFCompany X = (55 / 1.081) + (60.5 / 1.082) + (63.53 / 1.083) + (66.70 / 1.084) + (70.04 / 1.085) + (1,442.75 / 1.085) = 1231.83

$1.23 b is our estimate of Company X's present enterprise value. If the company has net debt, this needs to be subtracted, as equity holders' claims to a company's assets are subordinate to bondholders'. The result is an estimate of the company's fair equity value. If we divide that by the number of shares outstanding—say 10 m—we have a fair equity value per share of $123.18, which we can compare with the market price of the stock. If our estimate is higher than the current stock price, we might consider Company X a good investment.

Discounted cash flow models are powerful, but they are only as good as their imports. As the axiom goes, "garbage in, garbage out". Small changes in inputs can result in large changes in the estimated value of a company, and every assumption has the potential to erode the estimate's accuracy.

How to use DCF to value stock market? Read DCF Valuation: The Stock Market Sanity Check and Using DCF In Biotech Valuation

  1. Weighted Average Cost Of Capital ...

    Weighted average cost of capital (WACC) is a calculation of a ...
  2. Cash Flow

    The net amount of cash and cash-equivalents moving into and out ...
  3. Internal Rate Of Return - IRR

    A metric used in capital budgeting measuring the profitability ...
  4. Net Present Value - NPV

    Net Present Value (NPV) is the difference between the present ...
  5. Equivalent Annual Annuity Approach ...

    One of two methods used in capital budgeting to compare mutually ...
  6. Composite Cost Of Capital

    A company's cost to borrow money given the proportional amounts ...
Related Articles
  1. Stock Analysis

    Is Texas Instruments a Good Value Play?

    Find out whether investors and analysts believe that Texas Instruments would make a good value play at its current valuation, and learn more about its outlook.
  2. Stock Analysis

    Why Zynga's Stock Should Be On Your Radar

    Take a closer look at game developer, Zynga, and the reasons why the company's stock may be attractive to investors at the current share price.
  3. Fundamental Analysis

    Discounted Cash Flow Analysis

    Find out how analysts determine the fair value of a company with this step-by-step tutorial and learn how to evaluate an investment's attractiveness for yourself.
  4. Investing Basics

    Pin Down Stock Price With Real Options

    How can you assign a value to what a company may do with its business in the future? We explain how it works.
  5. Investing Basics

    DCF Valuation: The Stock Market Sanity Check

    Calculate whether the market is paying too much for a particular stock.
  6. Investing Basics

    Understanding The Time Value Of Money

    Find out why time really is money by learning to calculate present and future value.
  7. Investing

    Using DCF In Biotech Valuation

    Valuing firms in this sector can seem like a black art, but there is a systematic way to pin a price on potential.
  8. Markets

    Valuing A Stock With Supernormal Dividend Growth Rates

    If these calculations are off, it could drastically change the value of the shares.
  9. Fundamental Analysis

    Top 3 Pitfalls Of Discounted Cash Flow Analysis

    The DCF method can be difficult to apply to real-life valuations. Find out where it comes up short.
  10. Fundamental Analysis

    Taking Stock Of Discounted Cash Flow

    Learn how and why investors are using cash flow-based analysis to make judgments about company performance.
  1. When and why should the terminal value be discounted?

    Typically, an asset's terminal value is added to future cash flow projections and discounted to the present day. Discounting ... Read Full Answer >>
  2. When evaluating terminal value, should I use the perpetuity growth model or the exit ...

    In discounted cash flow (DCF) analysis, neither the perpetuity growth model nor the exit multiple approach is likely to render ... Read Full Answer >>
  3. What are the drawbacks of using the Dividend Discount Model (DDM) to value a stock?

    Drawbacks of using the dividend discount model (DDM) include the difficulty of accurate projections, the fact that it does ... Read Full Answer >>
  4. What does 100-plus accrued interest mean?

    The phrase "100-plus accrued interest" can be seen in reference to bond valuation and bond quotes. It means a bond has been ... Read Full Answer >>
  5. What metrics can be used to evaluate companies in the financial services sector?

    Two of the best metrics that can be used to evaluate companies in the financial services sector are the price-to-book (P/B) ... Read Full Answer >>
  6. How do I calculate free, discounted and operational cash flow in Excel?

    It's relatively simple and straightforward to calculate free or operating cash flow in Microsoft Excel; each only needs a ... Read Full Answer >>
  7. What value metrics are best for analyzing companies in the metals and mining sector?

    Discounted cash flow (DCF) analysis is often applied to companies in the mining business because accurate evaluation of a ... Read Full Answer >>
  8. What is the average price-to-book ratio in the railroads sector?

    Railroads generally have solid price-to-book, or P/B, ratios a bit above the 2.0 level; these levels are considered "good" ... Read Full Answer >>
  9. Why would you take DCF into account rather than simply projecting future revenues?

    Discounted cash flow, or DCF, analysis is preferred by market analysts for two basic reasons. One, because of the firmly ... Read Full Answer >>
  10. What is the difference between intrinsic value and current market value?

    There is a significant difference between intrinsic value and market value. Intrinsic value is an estimate of the actual ... Read Full Answer >>
  11. What industries tend to use discounted cash flow (DCF), and why?

    The nature of the calculations used in discounted cash flow, or DCF, analysis make it more properly suited for use in evaluating ... Read Full Answer >>
  12. How do you use DCF for real estate valuation?

    Discounted cash flow analysis, or DCF, is very commonly used in evaluation of real estate investments, although determining ... Read Full Answer >>
  13. How is impairment loss calculated?

    Impairment occurs when a business asset suffers a depreciation in fair market value in excess of the book value of the asset ... Read Full Answer >>
  14. How do I value the shares that I own in a private company?

    Share ownership in a private company is usually quite difficult to value due to the absence of a public market for the shares. ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Ex Works (EXW)

    An international trade term requiring the seller to make goods ready for pickup at his or her own place of business. All ...
  2. Letter of Intent - LOI

    A document outlining the terms of an agreement before it is finalized. LOIs are usually not legally binding in their entirety. ...
  3. Purchasing Power

    The value of a currency expressed in terms of the amount of goods or services that one unit of money can buy. Purchasing ...
  4. Real Estate Investment Trust - REIT

    A REIT is a type of security that invests in real estate through property or mortgages and often trades on major exchanges ...
  5. Section 1231 Property

    A tax term relating to depreciable business property that has been held for over a year. Section 1231 property includes buildings, ...
  6. Term Deposit

    A deposit held at a financial institution that has a fixed term, and guarantees return of principal.
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!