A discounted cash flow model values a business as the sum of the cash it will produce in future, each year discounted back to what it is worth today. It is the theoretically correct way to value anything that produces cash, and in practice its output is governed almost entirely by assumptions you cannot know.
The three inputs
Forecast cash flows. Usually free cash flow projected for five or ten years, built from revenue growth and margin assumptions.
The discount rate. The annual return you require, which converts future dollars into present ones. A higher rate means future cash is worth less today, so the valuation falls.
The terminal value. What the business is worth at the end of the forecast, usually calculated by assuming cash flows grow at a small constant rate forever.
Why the terminal value is the whole model
In a typical ten-year DCF, the terminal value accounts for roughly two thirds to three quarters of the total. That means the number most people spend their time on, the ten years of explicit forecasts, is the minority of the answer. The majority rests on a perpetual growth rate chosen from a narrow plausible band.
Move that rate from 2% to 3% and the valuation can rise 20% or more. Move the discount rate a point the other way and it moves again. Nothing about the business has changed. This is the central problem: the model is arithmetically precise and its inputs are guesses, so it produces confident answers that are wrong in ways the format conceals.
What a DCF is actually good for
It is a poor oracle and an excellent thinking tool. Building one forces you to state what you believe about growth, margins and reinvestment, and to notice when those beliefs are not mutually consistent. A company cannot grow 15% a year forever on falling reinvestment.
Treat the output as a range produced by a range of assumptions, never as a single number. If the answer only looks attractive at the optimistic end of every input, you have found an argument rather than a valuation.
The version worth using instead
A reverse DCF runs the model backwards. Rather than forecasting cash flows to produce a price, it takes today's price and solves for the growth the market is already assuming. That converts an unanswerable question, what will this company earn for the next decade, into a much easier one: is this expectation reasonable?
Judging whether a company can grow 12% a year for ten years is something you can actually reason about from its moat, its market and its history. That is why the reverse version is the one that survives contact with real decisions, and it needs no margin of safety bolted on afterwards to compensate for false precision.
Skip the spreadsheet
Stock Simplifier runs a reverse DCF on any US stock and tells you the growth rate baked into today's price, so you can judge the expectation instead of inventing a forecast. Free to start.
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Frequently asked questions
Related
- Reverse DCF, the same model run backwards, and the version worth your time.
- Intrinsic value, what the DCF is trying to estimate.
- Free cash flow, the cash a DCF discounts.
- Margin of safety, the defence against a valuation being wrong.