A Simple, Textbook Look at Discounted Cash Flow
When investors talk about “intrinsic value,” they’re often talking about some form of discounted cash flow, or DCF. It sounds intimidating, but at its core, DCF is just a structured way of answering a simple question: How much are this company’s future cash flows worth in today’s money?
The key idea behind DCF is the time value of money: a dollar today is worth more than a dollar tomorrow because you can invest it and because inflation erodes purchasing power over time. So if a business will earn cash for its owners in the future, those future dollars should be “discounted” back to the present using a rate that reflects risk and opportunity cost.
In textbook form, you:
- Forecast free cash flow for a number of years (say 5–10).
- Estimate a discount rate that reflects the return you require to compensate for risk.
- Add a terminal value to capture cash flows beyond your forecast period, often with a simple growth assumption.
- Discount each year’s cash flow and the terminal value back to today and sum them up to get a present value.
The math can look fancy, but conceptually it’s just: present value equals the sum of all future cash flows divided by one plus your discount rate, raised to the appropriate year. In a future post (or downloadable spreadsheet), I’d love to walk through a tiny example in Excel so you can see each step and play with the assumptions yourself.
If you’ve just read my earlier posts on thinking like an owner and buying future cash flows, DCF is simply the textbook way of putting those ideas into a single valuation framework.
