Definition
Discounted Cash Flow (DCF) is a valuation method used to estimate the present value of an investment based on its expected future cash flows. It’s widely used in corporate finance and investing to decide whether an asset or project is worth the cost today.
Why It’s Used
DCF answers one basic question: Is this investment worth it?
By estimating the amount of money a project or business will generate and adjusting those future earnings for the time value of money, investors can determine whether the potential return exceeds the initial cost.
How DCF Works
- It starts with forecasting cash flows that the investment is expected to generate over time.
- Then, a discount rate is chosen, typically based on the project’s risk and cost of capital.
- Finally, the future cash flows are discounted back to present value using that rate.
The opportunity may be attractive if the total present value of those future returns is higher than the current investment cost.
The DCF Formula
Where:
- CFn = Cash flow in year n
- r = Discount rate
- n = Number of years
Example of DCF
Imagine a company that wants to invest $11 million in a five-year project. Its expected annual cash flows look like this:
| Year | Expected Cash Flow |
| 1 | $1 million |
| 2 | $1 million |
| 3 | $4 million |
| 4 | $4 million |
| 5 | $6 million |
Using a 5% discount rate, the total present value of these cash flows equals roughly $13.3 million. Subtract the initial cost of $11 million, and the net present value (NPV) is $2.3 million. Since NPV is positive, the project is financially viable.
Where It Applies
- Valuing entire businesses or divisions
- Evaluating new product launches or capital projects
- Buying real estate or equipment
- Making investment decisions in equities or private equity deals
Advantages of DCF
- Focuses on cash—not accounting earnings
- Adapts to many types of investment scenarios
- Flexible enough to model different growth paths, risks, or time horizons
Limitations of DCF
- Highly dependent on estimates of future performance
- Sensitive to small changes in the discount rate or cash flow inputs
- Doesn’t reflect market sentiment or competitive pressures
- Shouldn’t be used in isolation—better when paired with other valuation methods
DCF vs. NPV
DCF calculates the present value of projected cash flows.
NPV goes one step further:
NPV=DCF−Initial Investment
If NPV is positive, the investment is worth pursuing.
DCF in Action: Quick Calculation Example
You’re evaluating an investment that promises $100 annually for 3 years. If your required return is 10%, here’s what each year’s cash flow is worth in today’s terms:
| Year | Cash Flow | Present Value |
| 1 | $100 | $90.91 |
| 2 | $100 | $83 |
| 3 | $100 | $75.13 |
Total DCF = $248.68
If the investment costs less than this amount, it may be worthwhile.
DCF in Stock Valuation
Some investors use dividend discount models (like the Gordon Growth Model), simplified versions of DCF, to value publicly traded stocks based on expected dividend payouts.
Discounted Cash Flow is a practical tool for valuing investments based on future profitability—adjusted for the time value of money. But it’s only as good as the assumptions behind it. When realistic estimates are paired with other analyses, DCF can offer sharp insight into what something is worth today.
