Concept Behind DCF Calculation: How Discounted Cash Flow Works

💡 What is Discounted Cash Flow (DCF)?

Discounted Cash Flow (DCF) is a method for estimating the value of a business or investment based on its expected future cash flows. The core idea is simple: money you receive in the future is worth less than money you have today, because of inflation and opportunity cost. DCF helps you figure out what those future cash flows are worth right now.

📐 DCF Formula & Key Inputs

To use DCF, you need to estimate a few things:

• Free Cash Flow (FCF): The actual cash the business generates after expenses, available to shareholders.
• Growth Rate (g): How much you expect FCF to grow each year.
• Discount Rate (r): Your required rate of return (reflects risk and opportunity cost).
• Forecast Period (n): How many years you’ll project into the future.
• Terminal Growth Rate (gₜ): The rate at which FCF grows after your forecast period (usually conservative).
• Net Debt (D): Total debt minus cash.
• Shares Outstanding (S): Number of shares issued.

🧮 Step-by-Step DCF Calculation

1. Forecast Future FCFs: Estimate FCF for each year using your growth rate.
   FCF_t = FCF_t-1 × (1 + g)
2. Discount Each FCF to Present Value: Bring each year’s FCF to today’s value.
   PV_t = FCF_t / (1 + r)^t
3. Calculate Terminal Value: Estimate the value beyond the forecast period.
   TV = FCF_n × (1 + gₜ) / (r - gₜ)
4. Discount Terminal Value to Present: Bring TV to today’s value.
   PV_TV = TV / (1 + r)ⁿ
5. Add All Present Values: Sum PV of FCFs and PV of TV to get Enterprise Value.
6. Calculate Fair Value per Share: Subtract Net Debt and divide by Shares Outstanding.

🏢 When Should You Use DCF?

• Great for established companies with steady earnings
• Not ideal for startups, turnaround stories, or cyclical businesses
• Use DCF as one tool among many for investment decisions

✨ DCF Example Calculation

⚠️ Common Pitfalls & Mistakes

• Over-optimistic growth rates: Small changes in growth or discount rate can swing your result wildly.
• Ignoring cyclicality: DCF doesn’t work well for businesses with unpredictable cash flows.
• Not updating assumptions: Markets and companies change—so should your DCF inputs.
• Forgetting about debt: Always subtract net debt to get equity value.
• Blind faith in the output: DCF is a tool, not a crystal ball. Use it alongside other valuation methods.

💡 Tips for Using DCF

• Be realistic with growth and discount rates—small changes can have a big impact.
• Always check if your cash flow forecasts are reasonable.
• Compare your DCF result with market price, but don’t rely on DCF alone.
• Use DCF for stable, mature companies—not for startups or highly cyclical businesses.
• Try different scenarios to see how sensitive your result is to assumptions.
• Read annual reports and industry trends to inform your inputs.

📝 Conclusion

DCF is a powerful tool for estimating the fair value of a company, but it’s only as good as your assumptions. Use it thoughtfully, compare with other methods, and always consider the bigger picture before making investment decisions. If you want to get better at DCF, practice with real companies and tweak your inputs to see how the results change.