Knowledge Base: Discounted Cash Flow Analysis (DCF) Tutorials

The Discounted Cash Flow (DCF) Model is one of the most important concepts in valuation and corporate finance and accounts for a high percentage of investment banking interview questions (and even interview questions in other fields, such as private equity and corporate development).

The big idea is that a company is worth its Cash Flow / (Discount Rate – Cash Flow Growth Rate), where its Cash Flow Growth Rate must be less than its Discount Rate.

The “Discount Rate” represents risk and potential returns – a higher rate means more risk, but also higher potential returns.

A company is worth more when its cash flows and cash flow growth rate are higher, and it’s worth less when these are lower.

The company is also worth less when it is riskier or when expectations for it are higher, i.e., when the Discount Rate is higher.

But the problem is that this formula only works if the company has “stabilized” and will no longer change much going into the future.

In real life, this never happens; companies grow and evolve, and their growth rates usually fall as they mature.

Therefore, companies are usually riskier in their earlier stages and become less risky over time.

So, in a full DCF model, you divide the analysis into an “explicit forecast period” where the company’s cash flows, cash flow growth rate, and Discount Rate change over 5-10+ years and a “terminal period,” where the Discount Rate and cash flow growth rate stop changing.

You value the company in both periods, add the results, and discount them to today’s values (if you haven’t already done so) to estimate the company’s implied value.

For more on this topic, please see the samples below and our comprehensive DCF Model tutorial.