Discounted cash flow basics: what a company's future cash is worth today

What you will learn

• Why a euro received in the future is worth less than a euro today, and how discounting works
• How to build a five-step discounted cash flow (DCF) model with a terminal value
• How to move from enterprise value to a value per share
• Why a sensitivity table matters more than a single "fair value"

Explanation

A discounted cash flow (DCF) model estimates the value of a business as the sum of all the cash it will generate in the future, translated into today's money. The cash flow used is usually free cash flow (FCF): operating cash flow minus capital expenditure, as explained in lesson 5 of this course.

Present value

Money received later is worth less today, because you could invest money now and because the future is uncertain. The present value (PV) of a cash flow received in year t is:

PV = cash flow ÷ (1 + r)^t

Here r is the discount rate, the yearly return you require for taking the risk. At r = 9%, €100 received in one year is worth €100 ÷ 1.09 = €91.74 today; received in two years, €100 ÷ 1.09² = €84.17. Companies often use the weighted average cost of capital (WACC), a blend of the required return of shareholders and lenders. For a private investor it is enough to choose a rate that reflects the risk: higher for small, indebted or cyclical companies, lower for stable ones.

The five steps

1. Forecast FCF for an explicit period, usually 5–10 years, based on revenue growth, margins and investment needs.
2. Discount each year's FCF to present value.
3. Estimate a terminal value (TV) for all years after the forecast. The common Gordon growth formula is TV = FCF in the first year after the forecast ÷ (r − g), where g is a permanent growth rate. Keep g low, typically no higher than long-run nominal economic growth; g must always be below r.
4. Discount the TV back to today with the factor of the last forecast year.
5. Bridge to equity: the sum is enterprise value. Subtract net debt (debt − cash) to get equity value, then divide by the number of shares.

Worked example

Hypothetical example: a company has FCF of €100 million next year, expected to grow 5% per year for five years, then 2% forever. Discount rate r = 9%. Net debt is €300 million, shares outstanding 50 million. All figures are invented; taxes on your own returns and trading costs are excluded.

• FCF in year 6 = 121.55 × 1.02 = €123.98 m.
• Terminal value at end of year 5 = 123.98 ÷ (0.09 − 0.02) = €1,771.17 m.
• PV of terminal value = 1,771.17 ÷ 1.09^5 (factor 0.6499) ≈ €1,151.14 m.
• Enterprise value = 426.26 + 1,151.14 = €1,577.4 m.
• Equity value = 1,577.4 − 300 = €1,277.4 m. Value per share = 1,277.4 ÷ 50 = €25.55.

Note that the terminal value provides 73% of the enterprise value. Most of a DCF result depends on what happens after year 5, which is the part you know least about.

Sensitivity table (value per share)

Small changes of one percentage point move the result from about €19 to about €37. The honest output of a DCF is therefore a range, not one number. Many investors then require a margin of safety: they only buy if the price is clearly below the cautious end of the range.

Common mistake

Practice activity

Hypothetical example: a small company expects FCF of €10 m, €11 m and €12 m in years 1–3, then 2% growth forever. Discount rate 10%, net debt €20 m, 10 million shares. On paper, calculate the value per share. Round discount factors to four decimals.

Key takeaways

• PV = cash flow ÷ (1 + r)^t; a higher discount rate means a lower value.
• Terminal value = next year's FCF ÷ (r − g), with g kept modest and below r.
• Enterprise value − net debt = equity value; divide by shares for value per share.
• Present a DCF as a range from a sensitivity table, and demand a margin of safety.

Next step

Part of the cash a company generates is paid to shareholders; the next lesson shows how to analyse dividends, their dates and whether they are sustainable.