DCF

Discounted cash flow (DCF) is a valuation method used to estimate the value of an asset, project, or business by calculating the present value of expected future cash flows. The approach rests on the principle that a dollar received in the future is worth less than a dollar today.

To perform a DCF analysis, analysts project cash flows for a forecast period and estimate a terminal value for cash flows beyond that horizon. These cash flows are then discounted back to present value using an appropriate discount rate, which reflects the opportunity cost of capital and the investment's risk.

Analysts may use different cash flow measures. Free cash flow to the firm (FCFF) represents cash available to all capital providers, while free cash flow to equity (FCFE) represents cash available to shareholders after obligations to debt holders. The choice affects the discount rate and valuation result.

For the forecast, terminal value can be calculated using a perpetuity growth model or an exit multiple approach. The discount rate is typically the weighted average cost of capital (WACC) for firm valuation or the cost of equity for equity valuation; CAPM or other methods are used to estimate the components of the rate.

DCF is widely used in corporate finance, investment analysis, mergers and acquisitions, and asset pricing. It requires careful judgement on cash flow projections, capitalization rates, growth assumptions, and risk factors; sensitivity analysis is often used to illustrate the impact of changing inputs.

Limitations include sensitivity to input assumptions, especially growth rates and the discount rate, potential mis-estimation of terminal value, and the omission of option value or strategic flexibility. DCF is most reliable when cash flows are predictable and well-supported by data.