Discounted cash flow (DCF)

Welcome. Today we will explore the Discounted Cash Flow method, or DCF, a central tool in corporate finance and valuation. DCF focuses on the fundamental idea that the value of a company, asset, or project equals the present value of all expected future cash flows it will generate. This technique is not just for financial analysts – it’s widely used by investors, managers, and even banks to support essential decisions, such as whether to invest in a project, determining a fair price to pay for a business, or evaluating if a potential acquisition is worthwhile. DCF enables a fact-based approach to these decisions, grounding estimates in expected cash generation over time. With DCF, we forecast cash flows over several years, typically five to ten, depending on the asset or project. Money received in future years isn’t as valuable as money received today, due to inflation and risk. To adjust for this, we discount those future cash flows back to their present value using a discount rate reflecting the project's risk and cost of capital. The DCF formula sums each year’s cash flow divided by one plus the discount rate to the power of each year, translating far-off returns into present value for clear comparison. Critical to a reliable DCF analysis are defensible estimates. This begins with accurately projecting future cash flows, which might be net income adjusted for non-cash items and capital expenditures, or more simply, free cash flow.