What a DCF Actually Does
A DCF values a business as the present value of the cash it will generate in the future. Everything else is detail.
- ✓Explain what a discounted cash flow model estimates
- ✓Name the transactions where a DCF is used
- ✓Describe why future cash is worth less than cash today
A discounted cash flow (DCF) model answers one question: what is a business worth today, based on the cash it will produce in the future? You forecast a company's future cash flows, then translate them into today's dollars using a that reflects how risky those cash flows are.
The value of a company derived from its own fundamentals - the cash its core operations will generate - rather than from what similar companies happen to trade for. A DCF is the purest expression of .
Where you will actually use it
DCF analysis shows up everywhere a price needs to be defended with logic rather than a market quote:
- M&A - what should an acquirer pay for a target?
- LBOs - can the cash flows support the debt, and what return do they imply?
- IPOs - what is a fair offer price for a company with no public market yet?
- Restructurings - what are the operating assets worth to creditors and new equity?
- Corporate decisions - should we build the plant, launch the product, buy the competitor?
A dollar tomorrow is worth less than a dollar today, because today's dollar can be invested to earn a return. Discounting is just running that logic in reverse: a future dollar is shrunk back to its value today.
The one formula to anchor on
Value is the sum of each future cash flow, divided by a growing . The further out a cash flow lands, the more it gets shrunk:
That is the whole engine. The rest of this track is about where the cash flows come from, what discount rate to use, and how to value the cash flows that arrive after your forecast ends.
Why is a cash flow received in 5 years worth less than the same amount received today?
Lock it in by building it yourself in a live, graded spreadsheet.