What Is Discounted Cash Flow

Discounted cash flow, or DCF, is a valuation method that forecasts a company’s future free cash flow, then discounts those future dollars back to today’s value using the company’s weighted average cost of capital, or WACC. The result is an estimate of what the company is actually worth right now, based on what analysts expect it to earn later.

Different Valuation Methods

Key Terms

• Forecasting: Predicting future value based on current metrics such as cash flow, share price, relevant ratios, etc.
• Capitalization (Cap) Rate: A percentage used to convert between market value and investment returns.
• Fair Market Value: The price at which an asset would be sold or bought under “perfect” circumstances, defined by both parties having knowledge about the asset and willingly participating in the trade.

There’s More Than Financials

When analyzing a company, it is critical to not only look at its financials, but be able to apply them to estimate long term performance. This is what “valuation” achieves.

The three main valuation methods, DCF analysis, Comparable company analysis and precedent transactions, are used across the finance industry to evaluate companies.

Method 1: Discounted Cash Flow

DCF (discounted cash flow) analysis forecasts businesses’s future free cash flow, and discounts it back to the present day based on the company’s weighted average cost of capital, also known as WACC.

The purpose of DCF analysis is to determine the current true value of a company based on its predicted future performance. A DCF analysis starts a model of the company’s financials, requiring significant analysis and assumptions.

A DCF model also allows analysts to make changes to their assumptions, adjusting for various business climates to see how it will impact the company in the future. When evaluating a large company, analysts will split into different components and conduct distinct analyses on each part. Eventually these are combined into a “sum-of-the-parts” analysis.

Overall, DCF analysis is the most detailed and thorough approach to valuation modeling, though it also takes the most work.

Method 2: Comparable Company Analysis

Comparable company analysis is a relative valuation method in which the present value of a company is compared to that of other similar companies. This is achieved through analyzing published trading multiples for various industries.

Typically, EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) is the most commonly compared metric, however others exist such as Price To Earnings and EV/EBITDA. This valuation method gives an actual observable value against other companies. This is the most common valuation methodology since the ratios used are easy to calculate and based on current information.

For Comparison’s Sake: Say Company X trades at 5 times their P/E ratio and Company Y has a P/E ratio of $10. If these companies have similar attributes and are comparable companies then Company Y should be valued at $50 per share.

Method 3: Precedent Transactions Analysis

Precedent Transactions Analysis is another form of relative valuation in which the company is compared to businesses that have sold or been acquired in the same industry. The values used include the entire cost of acquiring the business.

The value derived from this methodology is useful for M&A transactions. However, these analyses can easily become dated and no longer reflect the market since companies are not sold everyday and the market is always shifting. This methodology is less common than DCF or the comparable transaction method, however, is sometimes used in tandem with the latter.

The Bottom Line

For a quick understanding to begin analyzing a company, a comparable or previous transaction analysis may be in your best interest. If you are looking to dive deep into the valuation and be very detailed, DCF analysis is the way to go.

Questions:

1. What are the three main valuation methods mentioned in the article, and how does each one generally approach the valuation of a company?
2. Compare and contrast the use of Comparable Company Analysis and Precedent Transactions Analysis in industries with rapid technological advancements. Which method might provide a more accurate valuation, and why?
3. Why might an analyst use a "sum-of-the-parts" analysis when evaluating a large company, and how does this approach benefit the overall valuation process?

Why Analysts Rarely Use Just One Method

DCF analysis is powerful because it is built entirely from a company’s own projected numbers, but that is also its weakness: change one assumption about growth or WACC and the resulting value can shift dramatically. A small difference in the discount rate can move a DCF valuation by a wide margin, which is why analysts almost never rely on DCF alone.

In practice, an analyst might run a DCF model, then sanity-check it against comparable company multiples for similar businesses in the same sector. If the two methods land close together, that agreement builds confidence in the number. If they land far apart, it is usually a signal that one of the underlying assumptions needs a second look. Numbers alone don't capture everything a DCF model assumes about a company's future, which is why analysts often pair the math with a qualitative gut-check like a SWOT analysis worksheet before trusting the valuation.

Comparing valuation methods is easier with real numbers in front of you. Students can look up a public company’s current price and trading activity on Rapunzl Market Data, then test how a valuation assumption plays out by trading that stock inside the Rapunzl simulator with a virtual $10,000 portfolio. Watching a stock’s price move after an earnings report is one of the clearest ways to see the market revise its own assumptions about future cash flow in real time.

That gap between a DCF model and the market's actual price is often where the most interesting classroom conversations happen. A stock trading well below its DCF value might be undervalued, or the market might simply know something the model's assumptions left out.

Try It Yourself

This article is a sample from Rapunzl's What Makes a Good Stock? unit (Module 5). Rapunzl has reached 150,000+ students since 2018 — 81% students of color, with 83% of partner schools in low- and moderate-income communities.