The discounted cash flow (DCF) is one of the most popular valuation methods in finance and investment analysis. It allows you to pull all future cash flows expected to be received from an investment to a single starting point in time (now) to determine its value. This method relies on the principle that a dollar today will earn more money than a dollar tomorrow. This idea is reflected in the discounted cash flow (DCF) formula, where future cash flows are discounted back to present value.
In this blog, we will cover the discounted cash flow formula and how to calculate DCF, an in-depth DCF example, and how DCF valuation can be used to derive the intrinsic value of businesses and assets. We’ll also compare DCF and the NPV formula together so you have a full scope on how valuation works in a cash flow based way.
What is the DCF Formula?
The base formula of DCF is:
Where:
DCF=t=1∑n1+rtCFt
Where:
CFt = Cash Flow in year t
r = The discount rate or the required rate of return
t = Year number
n = The number of periods to forecast
Discounted Cash Flow DCF discounted cash flow formula is used to estimate the valuation by capitalising appropriate future expected cash flows. The DCF value is simply the sum of these discounted values and reflects the fair value of the investment today.
When to use the DCF formula?
There are several reasons that the discounted cash flow formula is so useful:
- Value: A crucial unit of value that helps identify the actual value of the company or the investment based on its generating cash capacity.
- Investment Decisions: Investors can use the DCF value in relation to the market value to make a judgment about whether an asset is under- or overvalued.
- Project Valuation: Those open up a new project or make an investment, Business utilises DCF For evaluate profitability.
WACC is also particularly significant for industries in which cash flows are predictable like utilities, real estate or mature manufacturing firms which normally would use DCF more often than WACC.
Read More: Discounted Cash Flow (DCF) Explained
The Components of the DCF Formula Explained
Now, let us detail each component of the DCF equation:
Cash Flow (CF): These are the over inflows the asset or investment is expected to generate each year. Commonly, FCF is applied.
Discount Rate (r): This represents the opportunity cost of capital or the risk of taking on this investment. So literally, what is WACC: WACC is often for businesses as well.
Forecast Period (t): The numbers of years that cash flows are estimated for. Most companies are projecting out 5–10 years.
Terminal Value: Companies do not die at end of 10 years which is why terminal value is often added to include cash flows after the forecast period.
How to Calculate DCF
To calculate DCF, use the following steps to help you understand how they are calculated:
Step 1: Excelled in Future Cash Flow Projection
Forecast the expected annual cash flows over the forecast period. That is, based on the past, market trends, and growth expectations.
Step 2: Select a rate by which you will discount the cash flows
The discount rate which is a measure of the investment risk. The higher the risk is, the more higher the discount rate should be. Analysts usually use WACC for companies.
Step 3: Calculate the Present Value of Each Cash Flow
Use the DCF formula to take each cash flow in the future years, and bring it back to the present value
Step 4: Terminal Value Calculation
If the forecast terminates after 5 or 10 years that forecasted cash flows will still have a terminal value. This calculation is generally performed by the use of the perpetuity growth model.
Step 5: Sum All of the Other Present Values
There are multiple forecasted cash flows, as well as a calculated value of the terminal value, which all contribute to the final DCF value.
Read More: Discounted Cash Flow Analysis
A Practical DCF Example
Below is a simple DCF example that demonstrates how this works in practice.
Step 1: Assumptions:
- Forecast period: 5 years
- Cash flows: $10,000 annually
- Discount rate: 8%
- Terminal growth rate: 3%
First, you will need to discount each cash flow for each year:
Step 2: Find the terminal value (TV):
We can calculate the terminal value using the formula:
TV=10,0001+0.030.08-0.03=206,000
Step 3: Aggregate all present values to get a DCF value:
The equation will look like the following:
DCF = 9,259 + 8,573 + 7,937 + 7,350 + 6,806 + 140,336 = 180,261
This investment enterprise has a DCF valuation of around $180,261.
Difference Between DCF and NPV
But the DCF and NPV formula are not the same things. NPV is used to analyse the profit of an investment project:
NPV=t=1∑n1+rtCFt-Initial Investment
Well that dcf gives you the present value of future cash flows and the npv gives you the dcf but subtracts out the initial outlay. An investment is profitable if NPV is positive.
Both approaches are based on the same fundamental methodology of discounting cash flows, but each is used for somewhat different purposes in valuation.
Advantages of DCF Valuation
Prospective: Number-based methods based on historical information, DCF valuation focuses on future expectations.
Scenarios Differentiated: Analysts can customise assumptions and differentiate scenarios, making sensitivity and decisions easier to analyse.
Used for Startups, Firms, Projects: The discounted cash flow formula provides a wide-ranging framework that can be used to value a wide range of assets from startups to established firms and even projects.
Read More: How to Build a Discounted Cash Flow (DCF) Model
Drawbacks of the DCF Formula
Intuitively, the DCF formula has great merit despite its merits it has a few flaws:
- Sensitivity to Assumptions: Minor adjustments in discount rate or assumptions about growth can drastically impact the valuation.
- Startups are Hard: For companies with negative or very infrequent cash flows, DCF methods may not be appropriate.
- Forecasting Complexity: Accurately estimating future cash flows requires a comprehensive knowledge of the industry and reliable data.
When to Use DCF Valuation
Use the DCF formula when:
- You require an in-depth analysis of a company’s prospectiveness.
- Market-based valuation methods (i.e., multiples) do not cut it.
- You suspect that someone is making a long-term investment with cash flows that are predictable.
- If the business has variable earnings, or if there aren’t already enough numbers to forecast, steer clear.
Conclusion
For a financial analyst, one of the most valuable tools is the discounted cash flow formula. The discounted cash flow (DCF) formula for valuing investments gives you a logic-based tool that translates expected future cash flows into present value terms, so you can compare against your investment criteria. If you are an investor, startup founder, or financial planner, understanding DCF calculation best prepares you to make the best decisions.
This guide walks you through everything from the details of each part of the formula to a real DCF example, using it as a comparison to the NPV formula, and much more—truly a complete summary of one of the core valuation tools in finance. With proper utilisation, DCF valuation can expose you to hidden opportunities and alert you to overpaying for assets—it is as fundamental to your strategic financial planning as it gets.
