Discounted Cash Flow (DCF) Explained

A Discounted Cash Flow (DCF) model tackles a tough question: what’s a company really worth today? This hinges on the "time value of money." $100 given to you now is worth more than $100 promised in five years. Why? You could invest today’s $100 and grow it. Plus, a future promise comes with the risk it might not happen.

A DCF works by projecting a company's cash flows for the next 5 to 10 years. Then, it discounts each future cash flow back to today's dollars using a discount rate. This rate reflects both the time value of money and the specific risk of that company's cash flows. Riskier businesses get discounted more than stable ones. You add up all those discounted values, along with an estimate for cash flows beyond the projection period, to find the company’s total value today.

The biggest weakness of a DCF is also its main feature: it's only as good as its assumptions. Even small tweaks in the growth rate or discount rate can change the final estimated value a lot. That’s why DCF is usually paired with other valuation methods, like comparing similar companies, instead of being relied on by itself.