What is a 'Discounted Cash Flow (DCF)'
A 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:
DCF is also known as the Discounted Cash Flows Model.
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.Â
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 accountÂ 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.Â
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 longterm cash flow growth rate, representing an assumption of annual growth from that point on. This value should probably not exceed the longterm 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 longterm valuation the company's growth approaches, is calculated using the Gordon Growth Model:
Terminal value = projected cash flow for final year (1 + longterm growth rate) /Â (discount rate  longterm 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:
DCF_{Company X}Â = (55 / 1.08^{1}) + (60.5 / 1.08^{2}) + (63.53 / 1.08^{3}) + (66.70 / 1.08^{4}) + (70.04 / 1.08^{5}) + (1,442.75 / 1.08^{5}) =Â 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 outstandingâ€”say 10 mâ€”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

Discount Rate
The interest rate charged to commercial banks and other depository ... 
Discounted AfterTax Cash Flow
An approach to valuing an investment that looks at the amount ... 
Present Value  PV
The current worth of a future sum of money or stream of cash ... 
Unconventional Cash Flow
A series of inward and outward cash flows over time in which ... 
Discounting
The process of determining the present value of a payment or ... 
Price to Free Cash Flow
A valuation metric that compares a company's market price to ...

Investing
Top 3 Pitfalls Of Discounted Cash Flow Analysis
The DCF method can be difficult to apply to reallife valuations. Find out where it comes up short. 
Investing
DCF Valuation: The Stock Market Sanity Check
Calculate whether the market is paying too much for a particular stock. 
Investing
Taking Stock Of Discounted Cash Flow
Learn how and why investors are using cash flowbased analysis to make judgments about company performance. 
Investing
Evaluate Stock Price With ReverseEngineering DCF
This is a more accurate method to use when trying to find a target price for a stock. 
Investing
DCF Vs. Comparables: Which One To Use
DCF and Comparables models are widely used in equity valuation. We explain the pros and cons of each method. 
Investing
Value Investing: Why Investors Care About Free Cash Flow Over EBITDA
Examine value investing philosophy and methodology to see why free cash flow is more important than EBITDA in pure intrinsic value calculation. 
Investing
Should You Use DCF for Valuation?
We explain the two primary valuation techniquesâ€”DCF and Comparablesâ€”used to predict future stock prices. 
Investing
Equity Valuation In Good Times And Bad
Learn how to filter out the noise of the market place in order to find a solid way of determing a company's value. 
Investing
How To Choose The Best Stock Valuation Method
Don't be overwhelmed by the many valuation techniques out there  knowing a few characteristics about a company will help you pick the best one. 
Managing Wealth
Valuing Startup Ventures
Valuing a company is a difficult task, regardless of the size of the business  but these methods can help.

How do I use discounted cash flow (DCF) to value stock?
Understand the meaning and significance of discounted cash flow, and learn how market analysts commonly use this stock evaluation ... Read Answer >> 
Why would you take DCF into account rather than simply projecting future revenues?
Learn what discounted cash flow analysis is and why it is considered a better equity valuation tool than simply projecting ... Read Answer >> 
How do I calculate free, discounted and operational cash flow in Excel?
Take a quick look at how you can calculate a company's operating cash flow, free cash flow and discounted cash flows using ... Read Answer >> 
What industries tend to use discounted cash flow (DCF), and why?
Understand the valuation method of discounted cash flow analysis and why it is more suitable for evaluating certain industries ... Read Answer >> 
When evaluating terminal value, should I use the perpetuity growth model or the exit ...
Examine the important calculation of a terminal value in discounted cash flow analysis, and learn which method of calculating ... Read Answer >> 
How is perpetuity used in determining the intrinsic value of a stock?
Learn about the basics of a perpetuity, its valuation, how it is calculated and how it is used when evaluating the intrinsic ... Read Answer >>