DCF explained: discounted cash flow for beginners

A discounted cash flow valuation estimates today's value of future cash flows. It makes the assumptions visible: the cash a business could generate, when it arrives and the rate used to discount it.

Start with one payment

A fictional £1,000 payment in one year is worth £909.09 at a 10% annual discount rate. The same payment in two years is worth £826.45. These are teaching assumptions, not recommended discount rates or promised returns.

From a payment to a business

A company model forecasts multiple years of cash flow and usually includes a terminal value for the period beyond the explicit forecast. Discount each amount to today and add the results. An enterprise valuation uses free cash flow to the firm with a matching discount rate such as WACC; an equity valuation uses cash flow to equity with the cost of equity. Mixing these approaches gives a misleading result.

An original HC example without terminal value

Imagine a project that produces £100,000 at each year-end for three years and then ends, with no residual value. At 10%, those cash flows have present values of £90,909.09, £82,644.63 and £75,131.48. Their sum is £248,685.20. If it costs £260,000 today, its net present value under those assumptions is −£11,314.80.

This example deliberately ends after year three. Applying it to an ongoing company without modelling later cash flows would omit part of the business. Adding an unsupported terminal value would create a different problem: apparent precision resting on an untested assumption.

Terminal value and sensitivity

A perpetual-growth approach estimates terminal value as next-period cash flow divided by the discount rate minus the long-run growth rate. The discount rate must exceed that growth rate. Small changes in either can move the valuation substantially, so compare a range of plausible assumptions rather than presenting a single number as fact.

Check the forecast

• Connect revenue growth to customers, pricing and capacity.
• Include taxes, capital expenditure and changes in working capital.
• Use consistent nominal or real cash flows and rates.
• Explain margins, reinvestment and the terminal assumption.
• Bridge enterprise value to equity value using consistent debt, cash and other claims.