Discounted Cash Flow (DCF)

Discounted Cash Flow (DCF) analysis is a valuation method that estimates the present value of an investment based on its expected future cash flows. The core principle is that money today is worth more than money in the future, so future cash flows must be discounted back to present value.

The DCF Process

First, project the company's free cash flows for typically 5-10 years into the future. Second, choose an appropriate discount rate, usually the weighted average cost of capital (WACC). Third, calculate the terminal value to capture value beyond the projection period. Finally, sum all discounted cash flows to arrive at the intrinsic value.

DCF is considered the most theoretically sound valuation method because it values a company based on what it actually generates for shareholders: cash. However, it is highly sensitive to assumptions about growth rates and discount rates. Small changes in these inputs can significantly impact the calculated value.

Fair Price Index uses DCF analysis as 50% of its blended valuation model, making it the most heavily weighted component. This reflects DCF's strong theoretical foundation while acknowledging its limitations through the inclusion of other methods.