Discounted cash flow step by step

A dollar next year is worth less than a dollar today

A dollar today can be invested and grow over the year, so a dollar you get a year from now is worth less. How much less depends on the required return: the return you want for taking the risk. At 9%, $1.09 a year from now is worth $1 today. This is called discounting, which is why the required return is also called the discount rate. How interest rates reach stocks is in the lesson on interest rates and the stock market.

Step by step

1. The cash flow. Start with free cash flow, the money left once the company has paid for running the business and its investments. What it is, is in the lesson on cash flow. Here it is per share and after interest, so it is the owners' money.
2. The growth. Estimate how fast the cash flow grows in the first years.
3. Discount. Divide each year's cash flow by 1 plus the required return, raised to the number of years.
4. The terminal value. The company carries on after the first years. Everything after that is treated as a cash flow growing by the same amount each year for ever: next year's cash flow divided by the required return minus the growth. That too is discounted back to today.
5. The total. Add it all up.

With $10 of cash flow per share this year, 10% growth for five years, then 2% a year and a required return of 9%, it looks like this:

Try it

The terminal value decides the most

In the example 75% of the value comes from the terminal value, the years after year 5. Raise the required return to 10% and the value falls to $177.50, 13% lower. Lower it by one point and it becomes $239.18, 17% higher. Small changes in the assumptions make big changes in the answer, so a DCF says more about what has to happen than about what something is worth. Lesson 4 turns the sum around and shows what growth a price assumes.