Understanding the Discounted Cash Flow (DCF) Valuation Method
The Discounted Cash Flow (DCF) method is a widely used valuation technique that estimates the value of an investment based on its expected future cash flows. The core principle is that an asset is worth the sum of all its future cash flows, discounted back to their present value. This approach is particularly popular for valuing companies, projects, or even individual assets, as it provides an intrinsic value rather than relying on market comparisons.
How the DCF Calculator Works
Our DCF calculator helps you estimate the intrinsic value of a company or project by following these key steps:
Projecting Free Cash Flow (FCF): The calculator starts with a "Current Free Cash Flow" and projects it forward for an "Explicit Forecast Period" (typically 5-10 years). During this period, you can specify different growth rates for different phases (e.g., higher growth in early years, then moderating).
Discounting Explicit Cash Flows: Each projected FCF is then discounted back to its present value using a "Discount Rate." This rate, often the Weighted Average Cost of Capital (WACC), reflects the riskiness of the cash flows and the opportunity cost of capital.
Calculating Terminal Value: After the explicit forecast period, it's assumed the company will continue to generate cash flows indefinitely. The "Terminal Value" captures the value of these cash flows beyond the explicit forecast period. It's typically calculated using the Gordon Growth Model, which assumes a constant "Terminal Growth Rate" into perpetuity.
Discounting Terminal Value: The Terminal Value, which represents a lump sum at the end of the explicit forecast period, is also discounted back to its present value.
Summing for Total Enterprise Value: The sum of the present values of the explicit cash flows and the present value of the Terminal Value gives you the "Total Enterprise Value." This represents the total value of the company's operating assets.
Key Inputs Explained:
Current Free Cash Flow ($): This is the starting point for your projections. It represents the cash a company generates after accounting for cash outflows to support operations and maintain its capital assets.
FCF Growth Rate (Years 1-5, %): The expected annual growth rate of Free Cash Flow for the initial high-growth phase.
FCF Growth Rate (Years 6-10, %): The expected annual growth rate for the subsequent, more mature growth phase.
Terminal Growth Rate (%): The constant rate at which Free Cash Flow is expected to grow indefinitely after the explicit forecast period. This rate should typically be modest and sustainable, often around the long-term inflation rate or GDP growth rate. It must be less than the Discount Rate.
Discount Rate (WACC, %): The rate used to discount future cash flows back to their present value. For a company, this is often the Weighted Average Cost of Capital (WACC), which reflects the average rate of return a company expects to pay to finance its assets.
Example Calculation:
Let's consider a hypothetical company with the following inputs:
Current Free Cash Flow: $1,000,000
FCF Growth Rate (Years 1-5): 10%
FCF Growth Rate (Years 6-10): 5%
Terminal Growth Rate: 3%
Discount Rate (WACC): 12%
Using these inputs, the calculator would perform the following steps:
Project FCF:
Year 1: $1,000,000 * (1 + 0.10) = $1,100,000
Year 2: $1,100,000 * (1 + 0.10) = $1,210,000
… (up to Year 5 with 10% growth)
Year 6: FCF_Year5 * (1 + 0.05)
… (up to Year 10 with 5% growth)
Discount FCFs: Each year's FCF is divided by (1 + 0.12)^year_number.
Sum PV of Explicit FCFs: Add up all the discounted FCFs from Year 1 to Year 10.
Calculate Terminal Value:
FCF_Year11 = FCF_Year10 * (1 + 0.03)
Terminal Value = FCF_Year11 / (0.12 – 0.03)
Discount Terminal Value: Terminal Value / (1 + 0.12)^10.
Total Enterprise Value: Sum of PV of Explicit FCFs + PV of Terminal Value.
The calculator will then present the final Total Enterprise Value, along with the breakdown of explicit cash flow present values and terminal value components.
Limitations of DCF:
While powerful, DCF is sensitive to its inputs. Small changes in growth rates, the discount rate, or the terminal growth rate can significantly alter the final valuation. It relies heavily on future projections, which are inherently uncertain. Therefore, DCF is best used as one tool among many in a comprehensive valuation analysis, often alongside comparable company analysis and precedent transactions.