Discounted Cash Flow (DCF) Valuation Method Explained

Ropa Ushe
July 4, 2025

Discounted Cash Flow (DCF) Valuation Method

The Discounted Cash Flow (DCF) method involves projecting future cash flows generated by a company and discounting them back to their present value using an appropriate discount rate. This method separates the cash flows into components based on the recipients:

  • Shareholders
  • Bondholders/Third-party lenders
  • Tax authorities

Steps include:

  1. Forecast net operating cash flows over a defined future period.
  2. Determine an appropriate discount rate that reflects the risk profile (e.g., equity risk premium, beta, liquidity premium).
  3. Discount the projected cash flows back to present value using the selected discount rate.

Advantages of DCF

  • Based on cash flow fundamentals of a company
  • Discount rate serves as a flexible tool to incorporate business and market risks
  • Customisable to different scenarios, assumptions, and business models

Disadvantages of DCF

  • Forecast accuracy diminishes with longer time horizons
  • Challenging to project cash flows for smaller or early-stage companies
  • Highly sensitive to assumptions, especially terminal value and discount rate
  • Data scarcity in certain regions/sectors can impact discount rate accuracy

Ropa Ushe

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