Discounted Cash Flow
Also known as: DCF, DCF Analysis, Intrinsic Valuation
A discounted cash flow (DCF) values a company by projecting its future free cash flows and discounting them back to today using a required rate of return.
A discounted cash flow analysis, or DCF, estimates what a business is worth based on the cash it is expected to generate in the future. Because a dollar received years from now is worth less than a dollar today, each future cash flow is discounted back to present value using a rate that reflects its risk.
The building blocks
- Free cash flow forecast. Usually five to ten years of projected free cash flow.
- Discount rate. Typically the weighted average cost of capital.
- Terminal value. A terminal value capturing all cash flows beyond the forecast window.
Strengths and weaknesses
A DCF is grounded in the fundamentals of the business rather than market sentiment, which makes it powerful for long-term thinking. Its weakness is sensitivity: small changes in the growth rate or discount rate can swing the answer dramatically. For that reason analysts usually pair a DCF with a market-based method like comparable company analysis.