What Is a Discounted Cash Flow (DCF)?
A discounted cash flow, or DCF, is a way of estimating what a business is worth today from the cash it is expected to produce in the future. You forecast the cash the company will generate each year, reduce each future amount to reflect that money later is worth less than money now, and add the results together. The total is an estimate of intrinsic value: what the business is worth on its own terms, whatever the share price says.
The idea is older than most of the companies it gets applied to. John Burr Williams set it out in The Theory of Investment Value in 1938, and Warren Buffett has described intrinsic value in the same terms: the discounted value of the cash that can be taken out of a business during its remaining life.
Why future cash is worth less
$100 today is worth more than $100 in ten years, because today's $100 can be invested in the meantime. If you could earn 8% a year, $100 now becomes $108 in a year. Run that backwards, and $108 arriving next year is worth $100 today.
That backwards step is called discounting, and the 8% is the discount rate. The discount rate is the yearly return you require for waiting, and for taking the risk that the cash never arrives.
How a DCF is calculated
There are five steps.
Forecast the free cash flow for each of the next five to ten years. Free cash flow is the cash a business generates from its operations, minus what it spends on equipment, buildings and other long-lived assets.
Choose a discount rate.
Discount each year's cash flow back to today.
Estimate a terminal value, which stands in for all the cash the business produces after the forecast ends, and discount that too.
Add everything up, subtract net debt (debt minus cash), and divide by the number of shares.
The formula for one year's cash flow is:
Present value = Cash flow ÷ (1 + discount rate)^number of years
For the terminal value, the most common method is:
Terminal value = Final year cash flow × (1 + long-term growth rate) ÷ (discount rate − long-term growth rate)
A worked example
The numbers below are invented, chosen to be easy to follow.
Free cash flow this year: $100 million
Growth for the next five years: 8% a year
Discount rate: 10%
Long-term growth after year five: 3% a year
Net debt: $200 million. Shares: 100 million
Cash flow grows from $108 million in year one to about $147 million in year five. Discounted back to today, those five years are worth roughly $98 million, $96 million, $95 million, $93 million and $91 million, or about $473 million in total.
The terminal value is $147 million × 1.03 ÷ (0.10 − 0.03), or about $2,162 million. Discounted back five years, it is worth about $1,342 million today.
Add the two and the whole business comes to about $1,816 million. Subtract $200 million of net debt, divide by 100 million shares, and the estimate is roughly $16 a share.
Now change one input. At a 9% discount rate, the same business comes out at about $19 a share. At 11%, about $14. Nothing about the company changed. Only the assumption did.
What reasonable inputs look like
A DCF has no good or bad result, only inputs that are more or less defensible. Typical ranges:
Discount rate: commonly 8% to 12% for an established company, and higher for businesses with less predictable cash flows.
Forecast period: five to ten years. Longer forecasts add false detail more often than they add accuracy.
Growth rate: anchored to what the company has achieved over many years, not to its best recent year. Growth slows as a business gets larger.
Long-term growth rate: usually 2% to 3%. It should not exceed the long-run growth of the economy, because a company that outgrows the economy forever would eventually become the economy. It must also sit below the discount rate, or the formula stops working.
These ranges shift by sector. A water utility with regulated income can justify a lower discount rate than a young technology company. A business in a shrinking industry may deserve a long-term growth rate of zero or less.
Because the growth assumption carries so much weight, it helps to run more than one. SIA company dashboards show three DCF scenarios side by side: one using the company's own growth record, one using its sector's average, and one using analyst estimates. The spread between them shows how much of the answer is assumption.
What a DCF doesn't tell you
The precision is an illusion. A DCF produces a figure to the cent from inputs that are educated guesses. In the example above, a one-point change in the discount rate moved the value by between 14% and 19%.
Most of the value sits beyond the forecast. In the example, the terminal value is about three-quarters of the total. That is typical. The part of the model you know least about carries the most weight.
It doesn't work for every business. Banks and insurers have no meaningful free cash flow, because borrowing and lending money is their operation. Companies that lose money, young companies with no track record, and cyclical businesses whose cash flow swings with the economy all produce values that depend heavily on which year the forecast starts from.
It can't check its own assumptions. The model will accept any growth rate you give it. That makes it easy to work backwards from a price someone already wants to justify.
It says nothing about timing. A share can trade below a sensible estimate of its value for years. A DCF estimates what a business is worth, not when the market will agree.
How to actually use it
Use a DCF to produce a range, not a single number. Run a cautious case, a middle case and an optimistic one, and pay the most attention to the cautious one.
Then leave room for being wrong. Benjamin Graham called this the margin of safety: only being interested when the price sits well below your estimate of value, so that an error in the estimate doesn't have to become a loss. Seth Klarman built an investing career, and a book title, on the same idea.
A DCF is often more useful run in reverse. Instead of asking what the business is worth, ask what growth rate today's price already assumes, and whether that looks achievable. That turns a forecast into a judgement you can check against the company's history.
Cross-check the result against other methods, such as comparing the company with similar businesses. And keep to companies whose cash flows you can reasonably forecast. Charlie Munger once said he had never seen Warren Buffett work a DCF out on paper. The lesson usually drawn is that if a business only looks cheap after detailed modelling, the gap is probably too thin to rely on.
The DCF calculator in the SIA valuation suite lets you set your own assumptions and see how far the result moves when you change them.
Common questions
What discount rate should I use?
There is no single correct figure. Many investors use the return they would require to own the business, often somewhere between 8% and 12%, and raise it for companies with less predictable cash flows. Whatever you choose, apply it consistently across the companies you compare.
Why do two analysts get different DCF values for the same company?
Because they chose different inputs. Small differences in growth and discount rates compound over many years, so two reasonable people can land far apart using identical maths.
The short version
A DCF values a business by adding up its expected future cash, with each year reduced for time and risk. It is the most direct way to connect a price to what a business produces. It is also highly sensitive to its inputs, dominated by the distant future, and unsuitable for banks and unpredictable businesses, so its output is a range to test and not a number to trust.
This article is educational and is not investment advice, and nothing in it is a recommendation to buy or sell any security. Avia Artis is not authorised or regulated by Finanstilsynet and is not registered with the SEC as an investment adviser or broker-dealer.
