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Fundamental Analysis · Pro · 5 min

Understanding the DCF model

You can explain how a discounted cash flow model turns future cash flows into a value today, and why its result depends so strongly on a few assumptions.

A dollar today vs. later

Would you rather have 100 dollars today or 100 dollars in five years? Almost everyone chooses today. Money now can be invested, and the future is uncertain.

That simple answer is the basis of the most widely taught valuation method in finance. It treats a company as a stream of future cash and asks what that stream is worth today. Analysts, investment banks and textbooks use it. Understanding how it works also shows why its results should be read with care.

Future cash, today's value

The present value of a future amount is what it is worth today. You find it by discounting: dividing by (1 + r) once for every year you have to wait. At 8% a year, 108 dollars in one year is worth 100 today, and 100 dollars in five years about 68.

A discounted cash flow model, or DCF, applies this to a whole company:

  1. Estimate the free cash flows for the next few years, often five to ten.
  2. Choose a discount rate: the yearly return investors require for the risk. For a whole company, analysts often use a weighted average of the cost of debt and the cost of equity.
  3. Estimate a terminal value for all the years after the forecast. A common shortcut assumes the cash flow grows at a small, steady rate forever: terminal value = next year's cash flow ÷ (discount rate − growth rate).
  4. Discount everything to today and add it up. Subtract net debt to get the value of the shares.

The fictional bicycle maker earns 50 million of free cash flow. Suppose it grows 4% a year for five years:

Value bars Free cash flows of 52 to 60.8 million over five years, discounted at 8% a year: their present values shrink from 48.1 million in year 1 to 41.4 million in year 5 and add up to 223.5 million today. The dashed outlines show the undiscounted amounts. FIVE YEARS OF FREE CASH FLOW 8% a year Year 1 48.1m Year 2 46.4m Year 3 44.6m Year 4 43.0m Year 5 41.4m Worth today 223.5m

The five years are worth 223.5 million today. For the years after, assume 2% growth forever. The terminal value at year 5 is 60.8 × 1.02 ÷ (0.08 − 0.02) = 1,033.6 million, worth 703.5 million today. In total, the business is worth about 927 million. Minus net debt of 140 million leaves 787 million, or 7.87 per share for its 100 million shares.

Same company, different value

Two things stand out.

First, the terminal value supplies about 76% of the total. Most of the result depends on what happens after year 5, which nobody can forecast well.

Second, the result is very sensitive to the discount rate:

Value bars The same model gives a value per share of 9.75 at a 7% discount rate, 7.87 at 8%, 6.54 at 9% and 5.54 at 10%. VALUE PER SHARE At 7% a year 9.75 At 8% a year 7.87 At 9% a year 6.54 At 10% a year 5.54

At 7% the shares are worth 9.75, at 10% only 5.54. The long-term growth rate matters just as much: with 3% instead of 2% growth forever, the value at 8% rises from 7.87 to about 9.36. With 1%, it falls to about 6.81.

The share trades at 10. Is it overvalued? Under these assumptions, yes. Under slightly more optimistic ones, it is about fairly priced. A DCF is most useful for asking a different question: what would I have to believe about growth and risk to justify today's price?

Common mistakes

The takeaway

A DCF values a company as the present value of its future cash flows. Small changes in the discount rate or long-term growth move the result a lot.

Check yourself

Quick quiz

4 questions. Instant feedback, nothing is saved.

  1. 1Tap the year whose cash flow is worth least today.

    Tap the chart.

    Value bars Chart for the question: Tap the year whose cash flow is worth least today. FIVE YEARS OF FREE CASH FLOW 8% a year Year 1 48.1m Year 2 46.4m Year 3 44.6m Year 4 43.0m Year 5 41.4m Worth today 223.5m

    Year 5 has the largest cash flow, 60.8 million, but it is discounted five times and is worth only 41.4 million today.

  2. 2What is 108 received in one year worth today at a discount rate of 8%?

    108 ÷ 1.08 = 100. Discounting is compounding in reverse.

  3. 3In the example, about three quarters of the value comes from the terminal value. Why does that matter?

    The terminal value assumes a growth rate forever. A small change there moves the result a lot.

  4. 4The discount rate rises from 8% to 9%. What happens to the value?

    Future cash is worth less today when the required return is higher. One percentage point cut the value by about 17%.

of 4 correct.

Sources

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