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What is a DCF valuation?

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The Daily Ledger · Markets

The banker's model ran to forty tabs, but the DCF valuation at the end came down to two assumptions nobody could verify.

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Overview

A discounted cash flow valuation, or DCF, estimates what a business is worth today from the cash it should produce later, scaled down for the wait. A future year counts for less than the same amount today, because money in hand can be invested and earn a return meanwhile. The numbers for distant years shrink the most. Add the scaled figures for the estimated value. The answer rests entirely on the forecast behind it, which is the standard criticism.
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Overview

A DCF puts a price on a business by guessing what cash it will throw off for years, then admitting money later is worth less than money now. Forecast the cash, shrink each year's cash amount for the wait, add it up. Everyone involved knows the forecast is a guess. It gets done anyway, because a DCF forces you to write down what you actually believe, on a line somebody else can point at and argue with. 😎

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Detail

A discounted cash flow valuation prices a business as the cash it will hand its owners in future, each year's cash scaled down for how long you wait to receive it. Building one takes three inputs. Forecast free cash flow for five or ten years. Pick a discount rate, usually the company's weighted average cost of capital, since that is what the money already costs. The higher the rate, the less a distant year counts. Then estimate a terminal value. That figure stands for what the whole business would be worth at the end of the forecast, much like a sale price in year ten. At a 10% rate, $100 in a year is worth about $91 today, and $100 in ten years about $39. Cash far out barely moves the answer, so the first few years and the terminal value decide most of the valuation. The terminal value alone is often more than half of it. Small changes in the discount rate move the result a long way, and the approach needs predictable cash, which rules out most young companies. It is used anyway, and the reason is the assumptions themselves. Building one forces a number onto growth, margins and risk, and those numbers are often more useful than the valuation they produce.
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Detail

A DCF values something by forecasting the cash it will produce each year, then shrinking every future year's cash down to what it is worth today. The whole thing rests on something everybody already knows: a hundred dollars now beats a hundred dollars in ten years. At a 10% discount rate, a hundred that is ten years out is worth thirty-nine now. Your forecast may stop at year ten and the business does not, so you bolt on a terminal value, which is really just your guess at what the whole thing would sell for in year ten. It is frequently more than half the answer. You pick the growth rate, you pick the discount rate, and out comes the valuation you were heading for. Which is why people call it a spreadsheet that tells you what you already decided. The defence is better than it sounds. The forecast assumptions now sit on a specific line, where somebody can point at them and say that is nonsense. A number with no assumptions attached cannot be argued with at all. The one thing worth remembering: whoever picks the discount rate has already picked the answer. 😎

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Analogy

A vending machine on a station platform is for sale. It clears about $3,000 a year, and you have twelve years of cash forecasts to work with. Twelve times $3,000 is $36,000, and that is not what the machine is worth. The $3,000 arriving in year eleven is worth less than this year's, which can be put to work in the meantime. So each year's cash forecast is reduced, the further out the more so. Add the new discounted numbers together and the total lands well below $36,000, with the early years supplying most of it. Then ask what the business itself will be worth in year twelve. That is the terminal value. Discount that too, add it to the discounted years, and the sum is the DCF valuation.
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Analogy

Someone offers to sell you their YouTube channel. They have a spreadsheet. Year one earns $8,000, every year after that is bigger, and the bottom line is a comfortable round number labelled value after year ten. To turn any of that into a price you shrink each future year for the wait, because $8,000 in year nine is not $8,000 today. Shrink it at 10% and the channel is worth $40,000. Shrink it at 20%, on the grounds that a channel is riskier than a savings account, and it is worth half that. Same views, same spreadsheet, different price. Always ask who picked the discount rate. 😎
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AI explanations may contain errors · Not professional advice

Formal definition — The same term, explained the usual way

Discounted cash flow analysis is a valuation method in which the projected free cash flows of an asset or enterprise are converted to present value using a discount rate that reflects the risk of those flows, most commonly the weighted average cost of capital. The valuation comprises the discounted explicit forecast period together with a terminal value, derived either from a perpetuity growth assumption or an exit multiple. The output is highly sensitive to both the discount rate and the terminal value assumption, and the method presupposes cash flows capable of being forecast with reasonable confidence.

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