Julian Shocron: Discounted Cash Flow, Step by Step
Julian Shocron explains the valuation method that looks forward rather than sideways: discounted cash flow, usually shortened to DCF.
What is the idea behind a DCF?
Money today is worth more than the same amount five years from now. It can be used or invested in the meantime, and there is always some risk it never arrives.
A DCF applies that idea to a business: it estimates the cash the business will generate in future years and converts it into today's money.
What goes into it?
- Future cash flows: the free cash flow expected each year (the free cash flow note explains what that is).
- A discount rate: the return demanded for waiting and for bearing risk. The riskier the business, the higher the rate.
- A terminal value: an estimate of everything the business is worth beyond the last year projected.
What does the formula look like?
Each year's cash flow is divided by (1 + rate) raised to the number of years until it arrives:
present value = year 1 cash flow / (1 + rate) + year 2 cash flow / (1 + rate)² + …
How would you value three years of the bakery's cash? (Invented figures)
Last year, the made-up bakery produced 35 of free cash flow. To keep things simple, assume it repeats that 35 each year for three years, discounted at 10%.
| Year | Cash flow | Divisor | Present value |
|---|---|---|---|
| 1 | 35 | 1.10 | 31.8 |
| 2 | 35 | 1.21 | 28.9 |
| 3 | 35 | 1.331 | 26.3 |
| Total | 105 | 87.0 |
The 105 received over three years is worth about 87 today. A full valuation would also add the terminal value.
Why is it useful?
- It looks at the business, not the market. It does not depend on what others are paying for similar companies.
- It forces assumptions into the open: how fast the business grows, how much it reinvests, how risky it is.
Why handle it with care?
- It is highly sensitive to assumptions. Moving the rate a couple of points can shift the result a lot.
- The terminal value often makes up more than half of the total, and it is the least certain part.
- Projecting is educated guessing. It is worth checking the result against a valuation by multiples.
The short version
A DCF estimates a business's future cash and brings it back to today with a rate that reflects time and risk. For the fictional bakery, 35 a year for three years at 10% is worth about 87.0 today. The method is powerful, but only as good as its assumptions.
Educational note by Julian Shocron. Not investment advice.
More notes by Julian Shocron: julianshocron.com/en