Discounted cash flow (DCF) is a valuation method used to estimate the attractiveness of an investment opportunity. DCF analyses use future free cash flow projections and discounts them, using a required annual rate, to arrive at present value estimates. A present value estimate is then used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one.

Calculated as:

DCF = [CF1/(1+r)1] + [CF2/(1+r)2] + ... + [CFn/(1+r)n] 

CF = Cash Flow

r= discount rate (WACC)

DCF is also known as the Discounted Cash Flows Model.

This is necessarily a simple treatment of a complex subject. More detail is beyond the scope of this article.

For these valuation purposes, a number of different DCF methods are distinguished today, some of which are outlined below. The details are likely to vary depending on the capital structure of the company. However the assumptions used in the appraisal (especially the equity discount rate and the projection of the cash flows to be achieved) are likely to be at least as important as the precise model used.

Both the income stream selected and the associated cost of capital model determine the valuation result obtained with each method. This is one reason these valuation methods are formally referred to as the Discounted Future Economic Income methods.

Equity-Approach

Entity-Approach

Flows to equity approach (FTE)

Discount the cash flows available to the holders of equity capital, after allowing for cost of servicing debt capital

Advantages: Makes explicit allowance for the cost of debt capital

Disadvantages: Requires judgement on choice of discount rate

Adjusted present value approach (APV)

Discount the cash flows before