Discounted Cash Flow (DCF)

Discounted Cash Flow (DCF) is a valuation method that calculates the present value of expected future cash flows. It's considered the most theoretically sound approach to valuation because it focuses on what a business actually generates.

The Core Concept: A dollar today is worth more than a dollar tomorrow. DCF discounts future cash flows back to their present value.

DCF Formula: DCF Value = Σ (Cash Flow_t / (1 + r)^t) + Terminal Value

Where:

• Cash Flow_t: Expected cash flow in year t
• r: Discount rate (WACC)
• t: Time period
• Terminal Value: Value of cash flows beyond forecast period

Step-by-Step DCF Process:

1. Project Free Cash Flows: Usually 5-10 years
2. Determine Discount Rate: WACC typically 8-12%
3. Calculate Terminal Value: Perpetuity growth or exit multiple
4. Discount Everything: Bring all values to present
5. Sum for Total Value: Compare to current price

Example (Simplified):

Year	Free Cash Flow	Discount Factor (10%)	Present Value
1	$100M	0.909	$91M
2	$110M	0.826	$91M
3	$121M	0.751	$91M
TV	$1,500M	0.751	$1,127M
Total DCF Value			$1,400M

Key Inputs:

1. Cash Flow Projections: Most sensitive input
2. Discount Rate (WACC): Higher = lower valuation
3. Growth Rate: Affects terminal value significantly
4. Terminal Value: Often 60-80% of total DCF value

Advantages:

• Theoretically rigorous
• Focuses on cash generation
• Forward-looking
• Company-specific analysis

Limitations:

• Highly sensitive to assumptions
• Difficult to project cash flows accurately
• Garbage in = garbage out
• Often produces wide valuation ranges