Discounted Cash Flow
Key Takeaways
- 01.Estimates value by discounting projected future cash flows back to the present day.
- 02.Uses WACC or a required rate of return as the discount rate to account for risk and time value of money.
- 03.Composed of two parts: discrete forecast period cash flows and terminal value.
- 04.Highly sensitive to small changes in growth and discount rate assumptions.
Why it matters
The DCF model is the most theoretically sound method to value a business: it treats a company as a cash-generating machine, asserting that a business is worth the sum of its future cash flows. It forces investors to think deeply about a company's growth sustainability, capital expenditures, and risk profile rather than relying on short-term market multiples.
When it matters
It is best applied to companies with predictable, stable, and positive free cash flows.
A 5-year FCF forecast showing discount factors and present value calculations.
Adjust the terminal growth rate and discount rate to see how they impact the final DCF valuation.
Common Mistakes
Using overly optimistic growth forecasts
Small changes in growth rate assumptions can inflate the DCF output. Investors often project high double-digit growth indefinitely, leading to buying overvalued stocks. Always run a sensitivity analysis with conservative estimates.
Ignoring capital expenditures
Using net income instead of Free Cash Flow in a DCF model ignores the capital expenditures needed to sustain growth, resulting in an artificially inflated valuation.
📖 Real-World Example: A conservative DCF valuation
An analyst valued a steady consumer staple company using a 5-year DCF. Projected FCF was grown at 4% per year, and a WACC of 8% was used. The resulting intrinsic value was calculated at $50 per share. Since the stock was trading at $40, it offered a 20% discount, representing a margin of safety.