What Is a Discounted Cash Flow (DCF)?
A discounted cash flow analysis values a business based on the cash it is expected to generate in the future, adjusted for the time value of money. The core idea is that a dollar received five years from now is worth less than a dollar today, so future cash flows must be discounted back to their present value.
Because a DCF is built from a company's own fundamentals rather than market prices, it is considered an intrinsic valuation method. It is also the single most tested technical topic in investment banking interviews, where "walk me through a DCF" is practically guaranteed.
DCF Step by Step
First, project unlevered free cash flow for an explicit forecast period, usually five to ten years, starting from revenue and working down through EBIT, taxes, depreciation and amortization, capital expenditures, and changes in working capital. Second, calculate a terminal value to capture all cash flows beyond the forecast period, using either the Gordon growth method or an exit multiple.
Third, discount both the projected cash flows and the terminal value back to the present using the weighted average cost of capital. Summing these present values gives enterprise value; subtracting net debt then yields equity value, which can be divided by shares outstanding to get an implied share price.
Example
Imagine a company expected to generate $100 million of free cash flow next year, growing modestly over five years, with a WACC of 10%. The year-one cash flow of $100 million is worth $100 / 1.10 = $90.9 million today, and a year-five cash flow of $120 million is worth $120 / 1.10^5 = $74.5 million today. If the five discounted cash flows sum to $420 million and the discounted terminal value is $780 million, the implied enterprise value is $1.2 billion. With $200 million of net debt, equity value is $1.0 billion.
Why It Matters
The DCF forces you to think about what actually drives value: growth, margins, reinvestment needs, and risk. It is used in M&A fairness opinions, equity research price targets, and internal corporate planning.
Its main weakness is sensitivity to assumptions, since small changes in WACC or terminal growth can swing the output dramatically, which is why analysts always pair a DCF with sensitivity tables and market-based methods.
