DCF intuition

A discounted cash flow, or DCF, values a business by estimating the cash it will generate in the future and working out what that cash is worth today. It is the valuation method most closely tied to finance theory, and "walk me through a DCF" is a classic interview question. At spring week level, interviewers care far more about whether you understand the logic than whether you can build a model.

Money now beats money later

£100 today is worth more than £100 in a year. You could put today's £100 in a savings account and earn interest, and there is always some risk that promised future money never arrives. Discounting reverses the effect of interest: it asks how much you would need today to end up with a future amount.

The discount rate is about risk

The discount rate is the return investors require for the risk they take. Riskier cash flows need a higher rate, which makes them worth less today. For a whole company, the usual rate is the weighted average cost of capital (WACC), which blends the return shareholders expect with the after-tax cost of debt. For a sterling valuation, the starting point is the yield on long-dated UK government bonds, called gilts, because that is the closest thing to a risk-free return in pounds.

The shape of a DCF

• Forecast free cash flow for a number of years, often five to ten
• Estimate a terminal value for all the years after the forecast
• Discount the forecast cash flows and the terminal value back to today
• Add them up to get enterprise value
• Subtract net debt and other claims to get equity value, then divide by diluted shares

Free cash flow here means unlevered free cash flow: the cash the operations generate after tax and after reinvesting in equipment and working capital, but before paying lenders. Because it is available to all capital providers, discounting it at WACC gives enterprise value. The superday lesson on DCF mechanics builds this line by line.

Terminal value

A company does not stop after five years, so the DCF needs a value for everything beyond the forecast. There are two common approaches.

• Perpetuity growth: assume cash flow grows at a steady rate forever
• Exit multiple: assume the business could be sold at a multiple of its final-year EBITDA

A cash flow that never grows is worth cash flow ÷ r. A cash flow that grows at rate g forever is worth next year's cash flow ÷ (r − g). This is often called the Gordon growth formula. The growth rate must be below the discount rate, or the formula breaks, and in practice it should be no higher than long-run growth in the economy, typically around 1% to 3%.

Terminal value often makes up well over half of a DCF's enterprise value. That is a useful thing to say in an interview, because it shows you know the valuation leans heavily on assumptions about the distant future.

What moves the value

Because small changes in the discount rate or growth rate can swing the answer a lot, analysts show a sensitivity table rather than a single value. For example, a table of values for discount rates from 7% to 9% against growth rates from 1% to 3%.

You may also hear of a levered DCF, which discounts the cash flow left for shareholders after interest and debt repayments at the cost of equity. That gives equity value directly. It is common for banks and other financial companies, where debt is part of the business itself.

Strengths and weaknesses

A DCF values the business on its own cash flows, so it does not depend on whether the market is currently expensive or cheap. But it is only as good as its inputs, and it is easy to reach almost any answer by nudging growth or the discount rate. That is why bankers use it alongside multiples and precedent deals rather than on its own.