Discounted Cash Flow (DCF)

A DCF is built on the time value of money: cash received in the future is worth less than cash today. The method forecasts future free cash flows, usually for five to ten years, estimates a terminal value for all cash flows after that and then discounts everything to the present using a discount rate that reflects the risk involved.

For a whole company, analysts typically forecast free cash flow to the firm and discount it at the weighted average cost of capital, giving the enterprise value. Subtracting net debt gives the equity value.

For example, if a company's forecast cash flows and terminal value are worth 800 million in today's money, and it has net debt of 200 million, the DCF suggests an equity value of 600 million.

DCF is widely respected because it focuses on the cash a business actually produces rather than on market sentiment. But it is very sensitive to assumptions. Small changes in growth rates, profit margins or the discount rate can change the result significantly, which is why analysts test different scenarios and compare DCF results with other valuation methods.