Why discount future money?
For two reasons: money you have today can be put to work and earn a return, and future money is not guaranteed. So any pound expected in a year counts for less than a pound today. The rate we discount by is called the discount rate.
The parts of the calculation
DCF applies the same idea to a company. You forecast the free cash it will bring in each year for a number of years, discount each year back to today, and add an estimated value for everything after that. The total is an estimate of what the company is worth.
Free cash has more than one definition. The example in the next lesson uses free cash flow to the firm (FCFF): the cash left from operations after taxes and investment in assets, before it is split between lenders and shareholders. It is discounted at the weighted average cost of capital (WACC), so the result is the value of the whole enterprise, and net debt is then subtracted to reach what belongs to shareholders. There is another route: free cash flow to equity (FCFE), discounted at the cost of equity, gives equity value directly, with no debt to subtract. Neither is exactly net profit, because a company can earn on paper while bringing in little cash.
Why is the result so sensitive?
In most DCF calculations the terminal value is the largest part of the total, and it rests on a growth assumption stretching many years ahead. Nudge the discount rate or growth a little and the result can move a lot. The next lesson has a full numeric example that shows this.
Start from the financial statements
Every DCF starts from the company's actual figures. Open any stock page and look at its profits and basic figures before thinking about any forecast.
Check yourself
1. At a 10% discount rate, what is EGP 1,100 in one year worth today?
2. If you raise the discount rate, what happens to the estimate?
Summary
- A pound today is worth more than a pound next year, so future money is discounted.
- DCF = expected free cash each year + terminal value, all discounted to today.
- The result is very sensitive to assumptions, so it is an estimate, not a price target.