Discounted Cash Flow (DCF), Explained Without the Jargon

The time value of money

Would you rather have $100 today or $100 in five years? Today, because you could invest it and have more than $100 in five years. Flip that around and a promise of $100 in five years is worth less than $100 today. How much less depends on the return you could earn elsewhere, the discount rate.

Present value = future cash ÷ (1 + discount rate)^years

Step 1: Start with free cash flow

Free cash flow is cash from operations minus capital expenditures. It's the cash a business generates after maintaining and growing its operations, the money that could in principle go to shareholders. Both numbers are on the cash flow statement in the 10-K. Use a normal year, or an average of several, not a single unusually good or bad one.

Step 2: Forecast the next ten years

Estimate how fast free cash flow will grow. Simple models use two stages: faster growth for years 1 to 5, slower growth for years 6 to 10, as competition catches up. Be honest: very few companies grow quickly for a decade.

Step 3: Discount each year back to today

Divide each year's cash flow by (1 + discount rate) raised to the number of years away. Add them up. That's the present value of the next ten years.

Step 4: Add a terminal value

A business doesn't stop after year ten. The terminal value estimates the value of all cash flows after that, assuming they grow at a slow, steady rate forever:

Terminal value = FCF in year 10 × (1 + g) ÷ (r − g)

Here g is the long-term growth rate and r is the discount rate. g must be lower than r, and is usually set near long-run economic growth. Discount the terminal value back to today just like any year-10 cash flow.

A worked example

Try it yourself with your own inputs:

What actually drives the answer

• The discount rate. In the example above, one percentage point moved the estimate about 14%.
• Long-term growth. Terminal value is often more than half the total, so the "forever" growth rate matters enormously.
• Starting cash flow. Starting from a peak year inflates everything after it.

Margin of safety

Because every input is a guess, many investors only buy when the price sits well below their estimate, a margin of safety. If your estimate is $97 and you'd want a 25% cushion, you'd look for a price around $73. The cushion is there to protect you from being wrong, which you sometimes will be.

The most useful trick: run it backward

Instead of asking "what is it worth?", ask "what growth does today's price assume?" Adjust the growth rates until the estimate equals the current price. If the answer requires 20% growth for a decade, you've learned something important about the risk you'd be taking.