Discounted Cash Flow (DCF)

The Discounted Cash Flow method values a company based on its expected future cash flows. These are discounted back to today because money in the future is worth less than money today. The sum of the discounted payments gives the estimated company value.

In practice the calculation has two stages: free cash flows are derived from the business plan for a detailed forecast period of usually five to ten years, and a terminal value is applied for the period thereafter, typically as a perpetuity with a constant growth rate. Under the common entity approach, cash flows before financing costs are discounted at the weighted average cost of capital. The result is enterprise value, from which net financial debt is deducted to arrive at equity value. The weight of the terminal value deserves attention, since under normal assumptions it often accounts for well over half of total value, so the choice of growth rate and cost of capital influences the result more than the detailed forecast of the early years. That is the method's well-known weakness: it is mathematically precise but highly sensitive to assumptions, which is why serious valuations always show sensitivities on cost of capital, growth and margins.

In Germany the capitalised earnings method described in the IDW standard is a closely related approach applying the same logic to the net inflows available to shareholders. In transactions the method usually serves as a cross-check alongside multiples and, in leveraged buyouts, alongside the buyer's return calculation. The origin of the forecast determines its reliability, because a model is only as good as its assumptions on volume, price, margin, capital expenditure and working capital. In practice the accuracy of earlier forecasts is analysed and the plan presented is adjusted accordingly. Consistency between cash flow and discount rate also matters, because a cash flow before financing costs is discounted at the weighted average cost of capital and cash flow to equity after interest, principal repayments and new borrowing at the cost of equity.