Discounted cash flow

A discounted cash flow model values a company by estimating the cash it will generate in each future year and converting each of those years back into today's money. Add them all up and you have what the business is worth. Every valuation Angie produces is one long DCF.

The discounting is the part that does the work. A dollar you receive in five years is worth less than a dollar today, for two reasons that compound: you could have invested today's dollar in the meantime, and the future dollar might not arrive. The wacc bundles both into a single rate, and the discount factor applies it.

The three moving parts

• The base. What the company earns in cash today. Angie uses a normalized figure, the dcf base, rather than the latest year, so one distorted year cannot set the whole trajectory.
• The path. How that cash changes over the horizon. Angie derives the growth rate from the company's own revenue history and fades it toward the perpetual growth rate.
• The tail. Everything after the horizon, collapsed into the terminal value. On a typical Angie valuation this is about 70 percent of the answer.

That last figure is the honest headline about DCF as a method. Most of what you are valuing happens after the part you explicitly modelled, which means most of the answer rests on two numbers: the perpetual growth rate and the discount rate. Small changes there move the result far more than anything in year three.

What a DCF is good and bad at

It is good at stable, cash-generative, moderately-growing businesses, because those are the ones whose future cash you can plausibly estimate. It is bad at almost everything else. A company with no positive free cash flow has nothing to discount. A company growing at 40 percent has a value that rests almost entirely on whether that continues, which no model can verify. A bank's cash flows are deposits and a loan book, and a DCF fabricates a large false discount on them.

The strongest argument for a DCF is not that it is accurate. It is that it forces every assumption into the open. A multiple hides all of them inside one number. A DCF makes you say what you think growth is, what you think the risk is, and what you think the business looks like in perpetuity. When it disagrees with the market, you can see exactly which assumption the disagreement lives in.