Discounted Cash Flow (DCF) Valuation

Per Present Value, any future sum of money is worth less today than its face amount, because of the time value of money — and per Net Present Value, that same idea extends to a whole stream of cash flows, not just one. A business is, at its core, just a much longer, less certain stream of future cash — the cash it's expected to generate for its owners, year after year. DCF valuation is the direct application of that same logic to an entire company: if you can estimate the cash flows a business will produce, and discount each one back to today, the sum of all those discounted amounts is a reasonable estimate of what the whole business is worth right now.

The one wrinkle a single project doesn't usually have is that most businesses don't have a fixed, known end date — a project might run for 4 or 5 years and then stop, but a healthy company could plausibly keep generating cash indefinitely. Rather than projecting cash flows forever, which nobody can do reliably, DCF valuation typically projects cash flows explicitly for a handful of years — often 5 to 10 — and then estimates a single lump-sum value, called the terminal value, that represents everything the business is expected to be worth from that point onward, assuming its cash flows keep growing at some steady, sustainable rate after that. The terminal value gets discounted back to today just like every other year's cash flow, and often ends up being the single largest piece of the total valuation.

The rate used to discount every cash flow is usually a company's cost of capital — often called WACC(weighted average cost of capital) — which blends the return a company's lenders require with the return its shareholders require, weighted by how much of the company is funded by each. It plays exactly the same role here as the discount rate in Net Present Value: too low a rate overstates the business's value, too high a rate understates it, and the whole estimate is only as trustworthy as the cash flow projections and discount rate that go into it — assumptions about a highly uncertain future, not verified facts.

Explicit projection years, plus a discounted terminal value:

Value = Σ [FCFₜ / (1+r)ᵗ]  (for each projected year)  +  Terminal Value / (1+r)ⁿ

Terminal Value = FCFₙ × (1 + g) / (r − g)

• FCFₜ — free cash flow projected for year t
• r— the discount rate, often a company's WACC
• g — the terminal (long-run) growth rate, assumed to continue forever after the projection period
• n — the number of years explicitly projected

The terminal value formula only makes sense when the discount rate is higher than the terminal growth rate — a business can't be assumed to grow faster than its discount rate forever without the math breaking down into an unrealistic, runaway number.

A small business projects $100,000 of free cash flow next year, growing 10% a year for 5 years, then a 3% terminal growth rate forever after, discounted at a 12% rate (its WACC).

Sum of discounted years 1–5:  ≈ $430,767
Terminal value (discounted back to today): ≈ $950,770

Total estimated value: ≈ $1,381,537

Notice that the terminal value — a single number built on the least certain assumption of all, a constant long-run growth rate — makes up nearly 70% of the total estimated value here. Try the DCF Valuation Calculator to see how sensitive the total is to the growth and discount rate assumptions.