What is Discounted Cash Flow? The Foundation of Intrinsic Value

Discounted Cash Flow (DCF) is a valuation method used to estimate the value of an investment based on its expected future cash flows.

A Discounted Cash Flow (DCF) analysis is a valuation method that estimates the value of an investment today based on projections of how much money it will generate in the future. The core premise is that the value of an asset is the sum of its future cash flows, discounted back to their present value. It is used by analysts at firms like Goldman Sachs to determine whether a stock is undervalued or to price an entire company during an acquisition.

The formula for a multi-period DCF is: $PV = \sum_{t=1}^{n} \frac{CF_t}{(1 + r)^t}$. Here, $CF_t$ is the cash flow in year $t$, and $r$ is the discount rate (usually the WACC). To account for the value of the company beyond the projection period (typically 5 to 10 years), analysts add a Terminal Value (TV). The Terminal Value often accounts for more than 70% of the total DCF valuation, making the choice of the perpetual growth rate a critical lever.

Analysts typically use Unlevered Free Cash Flow (UFCF) to value the entire business (Enterprise Value). UFCF is the cash available to all providers of capital, both debt and equity holders. It is calculated as EBIT less taxes, plus depreciation, minus capital expenditures and changes in working capital. In 2021, high-growth tech firms with negative net income were often valued via DCF by focusing on their long-term UFCF potential once they achieved scale.