Discounted Cash FlowDCF
Discounted cash flow values a company or project as the sum of its expected future cash flows, each discounted back to today at a rate that reflects risk. The result depends heavily on the growth and discount-rate assumptions, so small changes move it a lot.
A business is worth the cash it will produce in the future — but cash next year is worth less than cash today, and cash in ten years even less. Discounted cash flow (DCF) puts those two ideas together: forecast the cash, then shrink each year's amount back to a present value. It is the most widely used intrinsic valuation method, and also one of the easiest to fool yourself with. This entry walks through the steps with numbers.
- Category
- Fundamentals and Macroeconomics
- Reading time
- 5 min
- Also called
- DCF model, DCF valuation, Present value of cash flows
- Updated
DCF in plain words
Discounted cash flow values an investment by forecasting its future cash flows and discounting them to today.1
For companies, analysts usually discount free cash flow — the cash available to pay investors after running and investing in the business — rather than dividends, and find this more useful in practice.2
The big weakness is sensitivity: the answer swings with the cash-flow forecast, the terminal value and the discount rate.1
Building a DCF, step by step
Forecast free cash flow
Usually 5–10 years, from revenue, margins and investment. See Free Cash Flow.
Choose a discount rate
For the whole firm, typically the weighted average cost of capital. See Weighted Average Cost of Capital.
Discount each year
Present value = cash flow ÷ (1 + rate)^year. See Present and Future Value.
Add a terminal value
A value for all years after the forecast, often from a steady growth rate.
Sum to enterprise value
Then subtract net debt to reach the value of the equity. See Enterprise Value.
Divide by shares and test
Compare value per share with the price, and stress-test the assumptions.
Worked examples
Example 1 — Discounting three years of cash
PV ≈ $273A business is expected to generate $100, $110 and $121 over the next three years. The discount rate is 10%.
| Year 1 | $100 ÷ 1.10 ≈ $90.9 |
| Year 2 | $110 ÷ 1.10² ≈ $90.9 |
| Year 3 | $121 ÷ 1.10³ ≈ $90.9 |
| Present value | ≈ $272.7 |
Each future amount is shrunk to today's value before being added up.1
Example 2 — The terminal value
≈ 80% from terminal valueAfter year 3, cash flow is expected to grow 2% a year forever. Year-4 cash flow is $123.4; the discount rate stays 10%.
| Value at end of year 3 | $123.4 ÷ (10% − 2%) ≈ $1,543 |
| Discounted to today | $1,543 ÷ 1.10³ ≈ $1,159 |
| Total value | $273 + $1,159 ≈ $1,432 |
The terminal value is often most of a DCF's result, which is why its assumptions matter so much.1
Example 3 — Small changes, big swings
Assumption-drivenRepeat Example 2 with a 9% discount rate and 3% growth instead.
| Terminal value | $124.6 ÷ (9% − 3%) ≈ $2,077 |
| Discounted | $2,077 ÷ 1.09³ ≈ $1,604 |
| Change vs Example 2 | Value up by roughly a third |
A one-point change in two inputs moves the result by a third — the DCF is very sensitive to its assumptions.1
DCF vs valuation multiples
| Aspect | Discounted cash flow | Multiples (P/E, EV/EBITDA) |
|---|---|---|
| Approach | Intrinsic: value from future cash | Relative: compare with similar companies |
| Inputs | Forecasts, discount rate, growth | Current prices of peers |
| Strength | Forces explicit assumptions | Quick and market-based |
| Weakness | Very sensitive to inputs | Inherits market mispricing. See Price-to-Earnings Ratio |
Where DCF is used
Equity research
Most professional analysts use discounted free cash flow models alongside multiples.2
Mergers and acquisitions
Pricing a company before buying it. See Mergers and Acquisitions.
Project decisions
Accepting projects whose value exceeds their cost. See Internal Rate of Return.
Sanity checks
Testing what growth today's price already assumes.
Advantages and disadvantages
Advantages
- Grounded in cash, not accounting profit.
- Makes every assumption visible.
- Works for many kinds of companies and projects.
Disadvantages
- Highly sensitive to growth, margins and discount rate.
- The terminal value often dominates.
- Hard to apply to start-ups with no positive cash flow yet.
Going deeper
Read as far as you need. Each level builds on the one before it.
Why future cash is worth less
Beginner
Money today can be invested, and future money is uncertain, so each future dollar is discounted. The higher the risk, the higher the rate and the lower today's value. See Compound Interest.
Firm value versus equity value
Intermediate
Discounting free cash flow to the firm at the cost of capital values the whole business; discounting free cash flow to equity values the shares directly.2 The two should agree once debt is accounted for.
Reverse DCF
Advanced
Instead of forecasting, solve for the growth rate that makes the DCF equal today's price. If the market is implying growth far above anything the company has achieved, the stock is priced for perfection.
Common mistakes
Treating the output as fact
A DCF is only as good as its inputs.
Growth above the discount rate
The terminal formula breaks when growth approaches the discount rate.
Perpetual high growth
Long-run growth should not exceed the economy's.
Mixing cash flows and rates
Firm cash flow pairs with the cost of capital; equity cash flow with the cost of equity.
Check your understanding
Test yourself before moving on. Each answer comes with an explanation.
Key points to remember
- DCF values a business from its future cash flows.
- Each year's cash is discounted to today.
- The terminal value usually dominates the result.
- Small input changes can swing the answer widely.
- Use it with multiples and common sense.
Frequently asked questions
What discount rate should I use?
Can a DCF value growth start-ups?
Is DCF better than P/E?
Further learning
- Free Cash Flow
The cash a DCF discounts.
- Weighted Average Cost of Capital
The usual discount rate.
- Enterprise Value
From firm value to share value.
- Internal Rate of Return
The rate that makes the DCF break even.
Sources
This article is written in our own words. The sources below support the specific facts, rules and figures marked with a number in the text. Links open the original publisher’s page.
- Corporate Finance Institute. Discounted Cash Flow (DCF) Formula (opens in a new tab) Checked .
- CFA Institute. Free Cash Flow Valuation (Refresher Reading) (opens in a new tab) Checked .
Educational content, not financial advice. Examples use hypothetical prices and simplified costs; actual fees, margin rules and regulations vary by broker, market and country. We are not affiliated with any publisher linked above. Last reviewed . Report an error or request a source credit.