What is Discounted Cash Flow?
DCF valuation calculates what a business is worth today based on projected future cash flows. It accounts for the time value of money: a dollar today is worth more than a dollar tomorrow.
How DCF Works
Project free cash flows for 5-10 years. Calculate a terminal value for cash flows beyond that period. Discount all cash flows back to present value using a weighted average cost of capital (WACC). Sum them up.
DCF Limitations
DCF is highly sensitive to assumptions. Small changes in growth rates or discount rates dramatically affect the output. Use it alongside other methods, not in isolation.
How to Calculate DCF Step by Step
Step 1: Project free cash flows for 5-10 years. Estimate annual FCF based on revenue growth, margins, and capital needs.
| Year | Revenue | FCF Margin | FCF |
|---|---|---|---|
| 1 | $2M | -10% | -$200K |
| 2 | $3.5M | 5% | $175K |
| 3 | $5.5M | 12% | $660K |
| 4 | $8M | 18% | $1.44M |
| 5 | $11M | 22% | $2.42M |
Step 2: Choose a discount rate. This reflects the risk of the investment. For early-stage startups, use 30-50%. For established companies, 10-15%.
- Discount rate: 35%
Step 3: Discount each year's FCF to present value. PV = FCF ÷ (1 + r)^n
- Year 1: -$200K ÷ 1.35 = -$148K
- Year 2: $175K ÷ 1.82 = $96K
- Year 3: $660K ÷ 2.46 = $268K
- Year 4: $1.44M ÷ 3.32 = $434K
- Year 5: $2.42M ÷ 4.48 = $540K
Step 4: Calculate terminal value. Assume steady growth after year 5. Terminal Value = Year 5 FCF × (1 + growth) ÷ (discount rate - growth rate). With 5% perpetual growth: TV = $2.42M × 1.05 ÷ (0.35 - 0.05) = $8.47M. Discounted: $8.47M ÷ 4.48 = $1.89M.
Step 5: Sum it up. DCF Value = sum of discounted FCFs + discounted terminal value = -$148K + $96K + $268K + $434K + $540K + $1.89M = $3.08M
Common mistakes founders make:
- Using unrealistic growth projections (garbage in, garbage out)
- Choosing too low a discount rate for early-stage companies
- Over-relying on terminal value (it often represents 60%+ of the total, which is a lot of uncertainty)
- Using DCF for pre-revenue startups (comparable company analysis is more appropriate)
Formula
DCF = Σ (CFt / (1+r)^t) + Terminal Value / (1+r)^n
Where:
- CF = Cash Flow in period t
- r = Discount rate (WACC)
- n = Number of periods
Example
Simplified DCF for SaaS company:
- Year 1 FCF: $200K, PV: $182K
- Year 2 FCF: $300K, PV: $248K
- Year 3 FCF: $450K, PV: $338K
- Year 4 FCF: $600K, PV: $410K
- Year 5 FCF: $750K, PV: $466K
- Terminal Value PV: $3.5M
DCF Valuation = $5.14M
Using 10% discount rate.