# Discounted Cash Flow (DCF)

## Quick Definition

A valuation method that estimates business value by projecting future cash flows and discounting them to present value.

## What is Discounted Cash Flow?

DCF valuation calculates what a business is worth today based on projected future cash flows. It accounts for the time value of money: a dollar today is worth more than a dollar tomorrow.

## How DCF Works

Project free cash flows for 5-10 years. Calculate a terminal value for cash flows beyond that period. Discount all cash flows back to present value using a weighted average cost of capital (WACC). Sum them up.

## DCF Limitations

DCF is highly sensitive to assumptions. Small changes in growth rates or discount rates dramatically affect the output. Use it alongside other methods, not in isolation.

## How to Calculate DCF Step by Step

**Step 1: Project free cash flows for 5-10 years.** Estimate annual FCF based on revenue growth, margins, and capital needs.

| Year | Revenue | FCF Margin | FCF |
| --- | --- | --- | --- |
| 1 | $2M | -10% | -$200K |
| 2 | $3.5M | 5% | $175K |
| 3 | $5.5M | 12% | $660K |
| 4 | $8M | 18% | $1.44M |
| 5 | $11M | 22% | $2.42M |

**Step 2: Choose a discount rate.** This reflects the risk of the investment. For early-stage startups, use 30-50%. For established companies, 10-15%.

- **Discount rate: 35%**

**Step 3: Discount each year's FCF to present value.** PV = FCF ÷ (1 + r)^n

- Year 1: -$200K ÷ 1.35 = -$148K
- Year 2: $175K ÷ 1.82 = $96K
- Year 3: $660K ÷ 2.46 = $268K
- Year 4: $1.44M ÷ 3.32 = $434K
- Year 5: $2.42M ÷ 4.48 = $540K

**Step 4: Calculate terminal value.** Assume steady growth after year 5. Terminal Value = Year 5 FCF × (1 + growth) ÷ (discount rate - growth rate). With 5% perpetual growth: TV = $2.42M × 1.05 ÷ (0.35 - 0.05) = $8.47M. Discounted: $8.47M ÷ 4.48 = $1.89M.

**Step 5: Sum it up.** DCF Value = sum of discounted FCFs + discounted terminal value = -$148K + $96K + $268K + $434K + $540K + $1.89M = **$3.08M**

**Common mistakes founders make:**

- Using unrealistic growth projections (garbage in, garbage out)
- Choosing too low a discount rate for early-stage companies
- Over-relying on terminal value (it often represents 60%+ of the total — that's a lot of uncertainty)
- Using DCF for pre-revenue startups (comparable company analysis is more appropriate)

**Formula**

DCF = Σ (CFt / (1+r)^t) + Terminal Value / (1+r)^n

Where:

- CF = Cash Flow in period t
- r = Discount rate (WACC)
- n = Number of periods

**Example**

Simplified DCF for SaaS company:

- Year 1 FCF: $200K, PV: $182K
- Year 2 FCF: $300K, PV: $248K
- Year 3 FCF: $450K, PV: $338K
- Year 4 FCF: $600K, PV: $410K
- Year 5 FCF: $750K, PV: $466K
- Terminal Value PV: $3.5M

**DCF Valuation = $5.14M**

Using 10% discount rate.