How does a discounted cash flow valuation of a business work?

A discounted cash flow valuation, or DCF, works from a forecast. It projects expected cash flow, then converts it to a present amount using a discount rate. BDC’s glossary calls DCF the most common equity-based valuation method. This page describes the pieces and the questions to put to a valuator, using definitions from CBV Institute and BDC. It does not supply a rate or a result.

The pieces of a DCF

CBV Institute’s glossary defines the discounted cash flow method as a form of the discounted economic income method based on cash flow. It defines a discount rate as a rate of return used to convert economic income into present value, and present value as the value, as of a specified date, of expected economic income calculated using a discount rate. It defines terminal value as an estimate of the value of economic income of a business beyond the discrete forecast period, also known as residual value or continuing value.

When BDC points to it

BDC says discounted cash flow is used when cash flow is expected to fluctuate substantially in future years, such as when a company is growing rapidly. Its glossary says DCF establishes the value of a company using several different operating forecasts, and that analysts often begin with equity-based methods and project different scenarios for performance: best case, worst case and most likely. BDC lists capitalized cash flow beside it, used when cash flow is expected to remain stable in future years. See the capitalized cash flow method.

Check the assumptions

The method rests on a forecast, so check its assumptions. BDC says a valuator reviews past results and forecast cash flow or earnings, and may assess how reasonable the projections are. Ask who prepared the forecast, how the discount rate was supported, whether terminal value was used and why, and whether the cash flows were normalized. The glossary defines normalized earnings as economic income adjusted for extraordinary, nonrecurring, noneconomic or other unusual items. For the wider approach, see the income approach.