DiscountedCashFlowModellen

Discounted cash flow (DCF) analysis is a valuation method used to estimate the value of an investment based on its expected future cash flows. The core idea is that a dollar received in the future is worth less than a dollar today, so projected cash flows are discounted to present value and summed to derive an intrinsic value.

Analysts forecast cash flows for an explicit horizon, typically five to ten years, and estimate a terminal value to account for cash flows beyond the forecast period. The present value is calculated as the sum of each forecast cash flow divided by (1 + r)^t plus the terminal value divided by (1 + r)^N, where r is the discount rate and t is the year.

Cash flows can be defined in different ways. Free cash flow to the firm (FCFF) represents cash available to all providers of capital, and free cash flow to equity (FCFE) represents cash available to shareholders after debt service. The choice of a discount rate depends on the valuation type: weighted average cost of capital (WACC) for firm valuation, or cost of equity for equity valuation.

Terminal value is often estimated with the Gordon growth model: TV = CF_N+1 / (r - g), where g is a perpetual growth rate, or by applying a multiple to a final year metric.

DCF strengths include grounding in the time value of money and its applicability to investment decisions, mergers and acquisitions, and budgeting. Limitations include sensitivity to cash flow forecasts and discount rates, difficulties modeling volatile or early-stage firms, and potential tendency to reflect optimistic assumptions if inputs are not carefully validated.

The method has roots in early 20th-century financial theory, with John Burr Williams’s work laying the groundwork. It remains a standard tool in modern finance, widely taught and applied by practitioners such as equity analysts and corporate finance professionals.