What is a Discounted Cash Flow (DCF) Analysis?

A discounted cash flow (DCF) analysis is a valuation technique used to estimate the value of a business.

In a DCF analysis, one calculates the present value of a business by taking an estimate of future free cash flows and discounting them to the present using a discount rate.

The purpose of using a discounted cash flow analysis is to determine the intrinsic value of a business. If a DCF analysis indicates that a business should be valued above its current price, then there may be an investment opportunity in buying the business at a discount from its perceived value.

How to Perform a Discounted Cash Flow Analysis

Running a discounted cash flow analysis is a multi-step process that requires several calculations.

Step 1

The first step is to create an estimate of a business’s future cash flows.

This mandates some basic knowledge of the business in order to understand its future growth rate, profit margins, and investment needs. An analyst will generally estimate five to ten years of a business’s future cash flows.

Cash flow tomorrow is worth less than cash flow today, because cash today can be reinvested for a return; this concept is referred to as the time value of money.

Therefore, to determine the present value of a business, the cash flows need to be discounted to the present by a discount rate.

The most commonly used discount rate is the weighted average cost of capital (WACC) which takes into account a business’s cost of capital.

Step 2

Next, a terminal value needs to be calculated.

The terminal value is what the business could be worth following the last year of projected cash flow in the analysis.

There are two ways of calculating the terminal value: the perpetuity growth method and the exit multiple method. Once assessed, the terminal value must also be discounted to the present.

You can learn more about calculating a terminal value here.

Step 3

Finally, all the cash flows and the terminal value that have been discounted to the present are added up.

The sum of these values should approximate the enterprise value of the company, which is the total value of the company including its equity and debt capital.

To determine a company’s equity value, reduce the terminal value by the company’s net debt obligations. To get to a per-share equity value, divide the equity value by the company’s total shares outstanding.

The image below illustrates the many steps in a discounted cash flow analysis.