What Is Discounted Cash Flow (DCF)? Formula, Model and Examples

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Discounted cash flow (DCF) is a valuation method that estimates what an investment is worth today by projecting the cash it will generate in the future and converting each of those amounts into present value with a discount rate. The result is a single figure in today’s dollars. You can compare it with a purchase price, a project’s upfront cost or a company’s market value to judge whether the investment looks worthwhile.

The method rests on the time value of money: a dollar received today is worth more than a dollar received later, because today’s dollar can be invested and start earning a return right away.

What DCF measures

Discounting is compounding run backward. At a 5% annual rate, $1.00 deposited today grows to $1.05 in a year. Reversing that, a $1.05 payment due in one year is worth $1.00 today, and a $1.00 payment due in one year is worth about $0.95 today. The further away a cash flow is and the higher the rate, the less it is worth in present terms.

DCF fits any situation where money is paid now in expectation of receiving money later, from buying shares or acquiring a business to funding a project or pricing a bond.

The DCF formula

The discounted cash flow formula is:

DCF = CF₁ / (1 + r)¹ + CF₂ / (1 + r)² + … + CFₙ / (1 + r)ⁿ

where:

• CF₁, CF₂ … CFₙ = the cash flow expected in year 1, year 2, through year n
• r = the discount rate, expressed as a decimal
• n = the number of periods

Each cash flow is divided by (1 + r) raised to the power of the year in which it arrives. That divisor is the compounding factor; its inverse, 1 / (1 + r)ⁿ, is called the discount factor.

Hypothetical quick example: an investment pays $100 at the end of each of the next three years, and your discount rate is 10%.

• Year 1: $100 / 1.10 = $90.91
• Year 2: $100 / 1.21 = $82.64
• Year 3: $100 / 1.331 = $75.13

DCF = $90.91 + $82.64 + $75.13 = $248.68. You receive $300 in total, but at a 10% required return, that stream is worth $248.68 today. If the investment cost $200, its NPV would be $48.68.

The formula assumes each cash flow arrives at the end of its year. Some analysts apply a mid-year convention, discounting each year’s cash flow by half a period less on the reasoning that a business earns cash throughout the year. This raises the result slightly. Whichever convention you use, apply it consistently.

How a DCF model is built

A DCF model is a structured version of the formula, usually built in a spreadsheet, in this sequence:

1. Forecast cash flows for an explicit period, often five to ten years, based on revenue growth, margins, taxes, capital spending and changes in working capital.
2. Choose a discount rate that matches the risk and the type of cash flow being discounted.
3. Estimate a terminal value for all cash flows beyond the forecast period.
4. Discount everything to the present and add it up.
5. Convert to the value you need, for example from enterprise value to equity value per share.

Which cash flow to discount

Company DCF models generally use free cash flow, not accounting profit, because profit includes non-cash items and leaves out capital spending. There are three common versions, and the discount rate must match the cash flow:

If you mix them up, for example by discounting equity cash flows at WACC, the valuation is wrong. The Gordon Growth Model, a dividend discount model that assumes dividends grow at a constant rate forever, is the simplest member of the family.

Choosing the discount rate

The discount rate is the minimum return that makes the investment acceptable given its risk. For a company valuing a project with similar risk to its existing business, the usual choice is the weighted average cost of capital. WACC blends the return shareholders expect with the after-tax cost of debt, weighted by how much of each the company uses. For equity cash flows, the cost of equity is used instead, often estimated with the capital asset pricing model (CAPM).

Individual investors sometimes use their opportunity cost, the return they could earn elsewhere at comparable risk. The investor’s risk profile, the project’s riskiness and capital market conditions all move the appropriate rate; a riskier project warrants a higher rate, which lowers its present value.

Terminal value

A business does not stop after year five, so models add a terminal value representing all later cash flows. Two methods dominate:

• Perpetuity growth (Gordon) method: TV = CFₙ × (1 + g) / (r − g), where g is a long-run growth rate that must be lower than r.
• Exit multiple method: TV = a final-year metric, such as EBITDA, multiplied by a valuation multiple drawn from comparable companies.

The terminal value is calculated as of the final forecast year, so it must itself be discounted back by (1 + r)ⁿ.

Worked example of a DCF analysis

Hypothetical scenario: a company is considering a five-year project that costs $9.5 million upfront. Its WACC is 10%, so it uses 10% as the discount rate. Assume all cash flows arrive at year end and the project has no value after year five.

The project generates $14 million in nominal cash, but its DCF value is about $10.36 million. Subtracting the $9.5 million cost gives an NPV of $860,507. A positive NPV means the project is expected to earn more than the 10% required return, so on these assumptions it is worth pursuing. If the project cost $11 million, the NPV would be −$639,493, and the project would not clear the hurdle.

How sensitive the answer is

Rerun the same cash flows at a 12% discount rate, and the DCF drops to about $9.81 million. NPV against the $9.5 million cost falls to roughly $306,600. A two-point change in one assumption removed almost two-thirds of the project’s value. This is why analysts run DCF models across a range of discount rates and growth assumptions instead of relying on a single number.

Adding a terminal value

Now treat the same cash flows as a business that keeps operating. Assume cash flow grows at 2% a year forever after year five:

• TV at year 5 = $3,500,000 × 1.02 / (0.10 − 0.02) = $44,625,000
• Present value of TV = $44,625,000 × 0.6209 = about $27,708,614
• Total value = $10,360,507 + $27,708,614 = about $38.07 million

In this example, roughly 73% of the total value comes from the terminal value, that is, from cash flows more than five years away. In many company DCFs, the terminal assumptions carry more weight than the detailed forecast years, so the long-run growth rate deserves as much scrutiny as next year’s revenue.

How DCF is used

• Stock valuation: an analyst divides equity value by shares outstanding to get an intrinsic value per share, then compares it with the market price. A DCF value above the price suggests the stock may be undervalued on the analyst’s assumptions.
• Mergers and acquisitions: buyers use DCF to set a ceiling on what a target is worth to them, often alongside the synergies they expect.
• Capital budgeting: companies rank projects by NPV and approve those that exceed the cost of capital.
• Bond pricing: a bond’s price is the DCF of its coupons and principal at the market yield. A zero-coupon bond is the simplest case, with one cash flow: Price = Face value / (1 + r)ⁿ. A hypothetical $1,000 zero-coupon bond maturing in three years and priced at a 10% yield is worth $1,000 / 1.331 = $751.31.
• Real estate and private investments: rental income or distributions are projected and discounted in the same way.

Advantages and limitations of DCF

Advantages

• Based on fundamentals. DCF values an asset on the cash it produces, not on what the market pays for similar assets, which helps when prices look disconnected from the underlying economics.
• Broadly applicable. It works for any asset whose cash flows can be reasonably estimated, from a factory upgrade to a whole company.
• Transparent and testable. Every growth rate, margin and discount rate is visible, so others can challenge them, and inputs can be changed to test base, optimistic and pessimistic cases.

Limitations

• It runs on estimates. The output is a forecast, not a fact. Demand, economic conditions, technology, competition and unforeseen events all affect future cash flows and cannot be predicted reliably. Overestimating cash flows overvalues the investment; underestimating them can make a good opportunity look too expensive.
• High sensitivity. Small changes to the discount rate or terminal growth can swing the value widely.
• Poor fit for some assets. Early-stage companies with negative or highly uncertain cash flows, or very complex projects, are difficult to model meaningfully.
• Not a standalone tool. DCF is usually cross-checked against relative methods such as comparable company analysis and precedent transactions, which value a business by what investors pay for similar ones.

DCF vs. NPV, IRR and comparables

DCF and NPV are the most commonly confused. DCF gives the gross present value of what you will receive; NPV subtracts what you pay. In the worked example, DCF is $10.36 million and NPV is $860,507. A project passes when its IRR exceeds the required discount rate, which in simple cases like these is the same condition as a positive NPV.

FAQs

The Bottom Line

DCF helps investors, analysts and companies judge whether a stock, acquisition, project or bond is worth its price based on the cash it should produce. Because small changes to the discount rate or long-run growth can swing the result widely, run the model across a range of assumptions and cross-check it against comparable company analysis before relying on a single figure.