Discounted Cash Flow (DCF) Basics

Introduction

Discounted Cash Flow (DCF) estimates a company's intrinsic value by discounting its expected future cash flows to today's money. This lesson explains the concept and its sensitivity.

The Core Idea

A dollar today is worth more than a dollar later. DCF sums all expected future cash flows and discounts them back to present value using a discount rate that reflects risk.

Value = Sum of Future cash flows / (1 + discount rate)^year

The Ingredients

DCF needs:

1. Forecast future cash flows — estimates of how much cash the company will generate 2. A discount rate — reflects risk and opportunity cost (often based on cost of capital) 3. A terminal value — the value beyond the forecast period

Present Value Logic

A higher discount rate makes future cash worth less today:

Discount rate up  ->  present value down
Discount rate down -> present value up

This is why risky, high-growth companies are more sensitive to rates.

Sensitivity Is Everything

Small changes in assumptions change the value a lot:

• Growth rate
• Discount rate
• Profit margins

Strengths and Limits

• Strengths: based on real cash, not accounting tricks; a fundamental intrinsic value
• Limits: relies on forecasts that are often wrong; very sensitive to assumptions

Real-World Example

Two analysts value the same company. One assumes 8% growth and a 10% discount rate → value $120. Another assumes 5% growth and a 12% rate → value $80. The wide spread shows how assumption-driven DCF is.

Summary

• DCF = discounting future cash flows to present value
• Needs cash-flow forecasts, a discount rate, and a terminal value
• Higher discount rate lowers present value
• DCF is very sensitive to assumptions — run scenarios
• It's a powerful tool but only as good as its inputs

Next Lesson

A faster alternative: relative valuation with comparables.