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.
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.