Discounted cash flow, the core idea

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Key idea: A business is worth the cash it will produce in the future, with each future dollar shrunk to what it is worth today.

Discounted cash flow (DCF) is the most direct way to value a business. You estimate the free cash flow for each of the next several years, then convert every one of those future amounts into today's money and add them up.

Why convert? Because $100 arriving in five years is worth less than $100 today. You could put today's money to work in the meantime, and future money carries the risk it never shows up.

The conversion is called discounting. With a 10% discount rate, $100 a year from now is worth $100 / 1.10 = $90.91 today. Two years out it is $100 / 1.10 / 1.10 = $82.64.

A DCF is only as good as its inputs. Small changes to growth or the discount rate move the answer a lot, which is why it is best used alongside other methods rather than trusted alone.

Quick check

Using a 10% discount rate, roughly what is $110 received one year from now worth today?

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