Discounted Cash Flow
Discounted cash flow is a valuation method that estimates what a business is worth today by forecasting the cash it will generate in future years and reducing each year's figure by a rate that reflects the time value of money and the risk of not receiving it. The sum of those discounted cash flows, plus a terminal value for the years beyond the forecast, is the enterprise value.
- Also known as
- DCF, DCF valuation, Intrinsic valuation
- Used at
- valuation of any business, and the only method available for one with no comparable transactions
- Inputs
- a forecast of unlevered free cash flow (5–10 years), a discount rate (WACC), a terminal growth rate or exit multiple
- Output
- enterprise value; equity value follows from the bridge
- Sensitivity
- a one-point change in the discount rate typically moves the value by 10–15%
- In fintech
- the forecast carries the risk; regulatory scenarios are modelled as separate cases
How discounted cash flow works in practice
A multiple says what other people paid; a discounted cash flow says what the business should be worth on its own numbers. The model starts with a forecast of free cash flow year by year — revenue, margin, tax, capital spending, working capital — for as long as the forecast can be defended, usually five years for a mature business and longer for one still growing into its cost base. Each year's cash flow is divided by (1 + discount rate) raised to the number of years away, and the results are added. Beyond the forecast horizon a terminal value stands in for all later years, calculated either as a perpetuity growing at a modest rate or as a multiple of the final year's EBITDA; in a growth company it is commonly two-thirds of the total value, which is a warning about how much rests on assumptions about the distant future.
The discount rate is the weighted average cost of capital — the blended return the company's lenders and shareholders require — and it is where risk enters the calculation. A regulated payments business with recurring revenue is discounted at a lower rate than an early-stage lender whose losses are unproven.
In fintech deals the method's value is less the single number than the structure. A buyer models the base case, then a case in which interchange is capped, one in which the licence condition is not lifted, one in which the largest merchant leaves. The spread between those cases is what the earn-out and the escrow are sized to.
Example
A payments company is forecast to generate unlevered free cash flow of €4m, €5m, €6.2m, €7.3m and €8.1m over five years. At a 12% discount rate the present values are €3.57m, €3.99m, €4.41m, €4.64m and €4.60m — €21.2m in all. The terminal value at year five, with 3% perpetual growth, is €8.1m × 1.03 ÷ (0.12 − 0.03) = €92.7m, worth €52.6m today. Enterprise value is €73.8m, of which 71% is the terminal value. At a 14% discount rate the same forecast is worth €59.9m.
Common mistakes
- A forecast that grows for ten years at the rate the last two achieved. - A terminal growth rate above the long-run growth of the economy, which values the company as if it would one day be the economy. - Discounting levered cash flows at the WACC, or unlevered ones at the cost of equity. - Presenting one number instead of the range the sensitivities produce. - Forgetting that the model's precision is false: the third decimal of the discount rate matters more than any line in year one.