Financial Models

The Discounted Cash Flow (DCF) Model

Finance Guy

Finance Guy

— 3 min read

Imagine you could peek into the future and see exactly how much money a business will generate over time.

Would that help you decide whether to invest in it today?

That’s essentially what the Discounted Cash Flow (DCF) model does.

It’s one of the most widely used tools in finance to estimate the intrinsic value of a company, project, or asset by forecasting its future cash flows and translating them into today’s dollars.

In this post, we’ll break down the basics of a DCF model.

What is a Discounted Cash Flow (DCF) Model?

The DCF model answers a simple question: What is a stream of future cash flows worth today?

Since money today is worth more than the same amount in the future (thanks to inflation, risk, and opportunity cost), the DCF “discounts” future cash flows to reflect their present value.

If the total present value of those cash flows exceeds the current cost of the investment, it might be a good opportunity.

The Core Idea: Time Value of Money

The foundation of DCF is the time value of money (TVM). Here’s the gist:

  • $100 today ≠ $100 in 5 years.
  • If invest $100 today at 5% per year, this will equal $127.62 in 5 years.
  • Conversely, $100 received in 5 years is worth less than $100 today.

DCF reverses this logic: It tells you what future cash flows are worth right now.

Key Components of a DCF Model

Every DCF has three pillars:

1. Forecasted Free Cash Flows (FCF)

  • What it is: The cash a business generates after covering operating expenses and capital expenditures.
  • Why it matters: FCF represents the money available to investors (debt and equity holders).
  • Formula: FCF = Operating Cash Flow (OCF) - Capital Expenditures (CapEx) - Changes in Working Capital (NWC)
    • OCF = EBIT × (1 - Tax Rate) + Depreciation & Amortization

2. Discount Rate (Weighted Average Cost of Capital - WACC)

  • What it is: The rate used to “discount” future cash flows to today’s value. It reflects the riskiness of the investment and the cost of capital (debt and equity).
  • Why it matters: A higher discount rate reduces the present value of future cash flows (riskier investments = lower value).

3. Terminal Value (TV)

  • What it is: The value of all cash flows beyond the explicit forecast period (usually 5–10 years).
  • Why it matters: Most of a company’s value often lies in its long-term, steady-state cash flows.

How the DCF Model Works: A Simple Example

Let’s say a lemonade stand is expected to generate the following free cash flows over three years:

  • Year 1: $1,000
  • Year 2: $1,200
  • Year 3: $1,500

Assume a discount rate of 10% (reflecting the risk of the lemonade market).

Step 1: Calculate the present value (PV) of each year’s cash flow:

  • Year 1 PV: 1,000/(1+10%^1) = 909
  • Year 2 PV: 1,200/(1+10%^2) = 991
  • Year 3 PV: 1,500/(1+10%^3) = 1127

Step 2: Add the present values:

Total PV = $909 + $991 + $1,127 = $3,027

If you can buy the lemonade stand for less than $3,027, it might be undervalued!

Why Use a DCF Model?

  1. Intrinsic Valuation: DCF focuses on fundamentals, not market sentiment.
  2. Flexibility: Works for start-ups, mature companies, real estate, or even personal investments.
  3. Decision-Making: Helps answer:
    • Should I invest in this stock?
    • Is this project worth funding?
    • What’s a fair price for acquiring a business?

The Biggest Challenge: Garbage In, Garbage Out

DCF models are only as good as their assumptions.

Small changes in growth rates or discount rates can swing the valuation wildly. For example:

  • Overestimating growth = Overvalued business.
  • Underestimating risk = Too low a discount rate.

This is why DCF is often paired with sensitivity analysis (testing different scenarios).

When to Use (and Avoid) DCF

Use DCF when:

  • The business has predictable cash flows (e.g., established companies).
  • You need a long-term perspective.

Avoid DCF when:

  • Cash flows are highly uncertain (e.g., early-stage start-ups).
  • The company is in a volatile industry (e.g., crypto, biotech).

Conclusion

The DCF model is like a financial time machine—it helps you weigh the value of future cash flows against the cost of investing today.

While it requires careful assumptions and a solid grasp of financial basics, it’s an indispensable tool for investors, analysts, and business leaders.

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