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How do you know how much an investment is worth? Conducting a discounted cash flow (DCF) analysis is the best way to arrive at an educated guess, whether you’re looking at the cost for a specific project, purchasing shares of a publicly traded company or investing in a private business.

Previously, we looked at how private and public comps help analysts compare companies within a similar growth stage and industry to determine a company’s current market value. When used alongside an intrinsic valuation method like discounted cash flow analysis—which looks at the value of an investment based on its projected future cash flows—these models can help investors, business owners and transaction advisors gauge a company’s current market value, and then assess if that company is under- or overvalued.

Here we explore the discounted cash flow model and why this valuation method is important to use in conjunction with public and private comps whenever assessing the value of a business.

What is discounted cash flow analysis?

Discounted cash flow analysis is an intrinsic valuation method used to estimate the value of an investment based on its forecasted cash flows. It establishes a rate of return or discount rate by looking at dividends, earnings, operating cash flow or free cash flow that is then used to establish the value of the business outside of other market considerations.

In other words: It looks to answer the question, “How much money will I get from this investment over a period of time and how does that compare to the amount I could make from other investments?”

It does this by adjusting for the time value of money—which assumes a dollar invested today is worth more than a dollar invested tomorrow because it’s generating interest over that period.

How do you conduct discounted cash flow analysis?

To conduct a DCF analysis, assumptions must be made about a variety of factors, including a company’s forecasted sales growth and profit margins (its cash flow) as well as the rate of interest on the initial investment in the business, the cost of capital and potential risks to the company’s underlying value (its discounted rate). All these considerations are then combined in a discounted cash flow model to shine light on the future cash flows of an investment. The more insight into a company’s financials you have, the simpler it is to do.

With so many variables though, it’s easy to see why pricing a deal can be difficult, and why most investors and transaction advisors choose to use multiple types of valuation models to inform their decision-making along with DCF analysis. An accurate answer helps inform how much an investment is currently worth—and which deals are worth walking away from.

What are the main three inputs of a discounted cash flow model?

Discounted cash flow models typically consider three values:

• DCF—Discounted cash flow, which is the sum of all future discounted cash flows that an investment is expected to produce
• CF—Cash flow for a given year
• r—Discount rate, or the target rate of return on the investment expressed in decimal form

 

Here’s the basic discounted cash flow formula for a simplified analysis:

Keep in mind, there are a wide range of formulas used for DCF analysis outside of this simplified one, depending on what type of investment is being analyzed and what financial information is available for it. This discounted cash flow formula is simply meant to highlight the general reasoning used in the process.

What is an example of calculating discounted cash flow analysis?

Let’s say you’re looking at buying a 10% stake in a private company. It has an established business model that’s profitable and its revenue is growing at a consistent rate of 5% per year. Last year, it produced $2 million in cash flow, so a 10% stake would’ve likely given you $200,000 had you purchased it last year.

Here’s a simplified explanation of how DCF analysis could help you determine how much you should reasonably pay for that 10% stake:

This year, the business would give you $210,000, assuming the company’s established 5% YoY revenue growth. Next year, $220,500, and so on, assuming the company’s growth rate stays consistent.

Let’s also assume your target compound rate of return is 14%—that is to say, the rate of return you know you can likely achieve on other investments. This means you wouldn’t want to purchase the stake in the business unless you knew you could achieve at least that rate of return; otherwise, you’re better off investing your money elsewhere. Because of this, 14% becomes the discount rate (r) you apply to all future cash flows for the prospective investment.

 

The numerators in the discounted cash flow formula above represent the expected annual cash flows, assuming a 5% YoY growth rate. Meanwhile, the denominators convert those cash flows into their present value since they’re divided by your target 14% annual compound interest. The DCF is the sum of all future cash flows and is the most you should pay for the stake in the company if you want to realize at least 14% annualized returns over whatever time period you choose.

For the sake of simplicity, let’s say you’re only looking out three years for this investment. The table below illustrates how in this example, even as the expected cash flows of the company keep growing, the discounted cash flows will shrink over time. That’s because the discount rate is higher than the growth rate—meaning you’d make more money on your investment elsewhere, provided you were certain you could reach your target rate of return through other means.

Year	Cash flow	Discounted cash flow
1	$210,000	$184,210
2	$220,500	$169,668
3	$231,525	$156,273
Total	$662,025	$510,151

In this scenario, even though you’d hypothetically receive $231,525 in cash flow in year three of your investment, that would only be worth $156,273 to you today. Reason: If you invested that same amount today and realized a 14% YoY return on it through another investment, you would have turned it into $231,525 in that same time period. And because the discount rate (14%) is higher than the growth rate of the company’s cash flow (5%), the discounted versions of those future cash flows will continue to decrease in value each year until they reach zero.

Assuming your target YoY rate of return is 14% for this investment and your exit window is three years out, $510,151—the total DCF for that time period—is the most you should pay for the 10% stake at this time.

What are the advantages and disadvantages of discounted cash flow techniques?

In using discounted cash flow models to gain insight into an investment’s value, it’s important to consider the benefits and drawbacks of this approach. Namely, this method of valuation relies on estimates, and the projection can only be as good as the accuracy of these assumptions.

Advantages of discounted cash flow analysis

DCF values company’s or investments through a unique lens, offering some unique benefits over alternative valuation methods:

• DCF allows for objective valuations independent of market factors. Since it calculates value apart from subjective market sentiment, it is considered a more objective valuation method than other alternatives. The market can often misprice companies, and the DCF is unaffected by temporary market distortions.
• DCF considers the long-term value of a potential investment. DCF assesses the potential earnings of an investment over the long-term, considering the time value of money and allowing investors to estimate how long it will take them to see a certain level of return.
• DCF is an extremely detailed approach to valuations. DCF uses specific numbers and metrics that are derived based off assumptions about a business, including cash flow projections and discount rates. If these assumptions are accurate, it can provide a good picture of a company or investment’s value.

Disadvantages of discounted cash flow analysis

While DCF has some unique characteristics over other valuation methods, there are also some important limitations to consider:

• DCF analysis depends on accurate estimates. DCF models rely heavily on the assumptions previously mentioned, and if these estimations are inaccurate, it can have a significant impact on the investor. For example, if an investor estimates future cash flows to be too high, it can result in an investment that won’t pay off in the future, hurting profits. Conversely, assuming cash flows to be too low can result in missed opportunities.
• A discounted cash flow model requires significant data. Creating a DCF model requires a significant amount of financial information that can be difficult and timely to obtain and analyze.

DCF vs NPV: How do you calculate NPV from DCF?

Often, investors use NPV along with DCF when vetting the profitability of an investment. The net present value (NPV) builds upon the DCF formula by considering the cost of an initial investment through adjusting for the initial investment costs. In other words, it represents the present value of all future discounted cash flows subtracted by the original amount an investor paid for an investment. Calculating the NPV typically involves three values:

• CF_n—the cash flow in each year of an investment
• r—the discount rate or the target rate of return on the investment expressed in decimal form
• Initial investment—the amount paid for the investment

Here’s the basic formula for NPV:
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The result of calculating NPV can be positive or negative, as the initial investment costs to fund a given project can be either higher or lower than its present value. When NPV is positive, it demonstrates that there is additional value that can be made from an investment. Alternatively, when NPV is negative, it shows that the investment cost is greater than the cash flows the investment will generate over its lifespan. Therefore, NPV is often used by investors to determine the rationality of an investment.

DCF vs comparables: When should you use each approach?

Calculating discounted cash flow analysis is just one approach to calculating valuations. Building comparables and an accurate peer group is another. The widely accepted way to arrive at a valuation for a company combines a series of the three DCF models: private comps, public comps and discounted cash flow analysis.

DCF analysis will make it clearer how long it might take to see a certain level of return, whereas a comparable gives better insight into the mood of the market. Finding the inputs for a DCF analysis can also be more difficult than a comps analysis if you don’t have a trusted data source.

​How to save time on your next company valuation

Accurately valuing a private company requires insight into the flow of capital across the entire venture capital, private equity and M&A landscape—not to mention the public markets. The process can take up a lot of valuable analyst time, especially if your firm uses legacy valuation tools and data that live on different systems.

Integrating a tool like PitchBook into your workflow means you have access to the world’s largest database of multiples and valuations as well as a suite of tools designed specifically to help you to work more efficiently.

We know that along with accuracy, speed is essential when building DCF models. A thoroughly vetted transaction or company comparable analysis won’t do you much good if your target signs with someone else while you’re doing it.

PitchBook lets you build financial models in a matter of minutes. By allowing you to quickly identify different types of funding rounds, companies and financings, PitchBook enables you to seamlessly navigate between datasets to find relevant transactions fast.​​​​​​

Learn more about evaluating cash flows

Explore best practices for forecasting cash flows of private market funds
Read our blog: Best practices for optimizing cash flow forecasting

Gain a full view into how LPs can mitigate cash flow forecasting and commitment pacing challenges  
Download our Allocator solutions: cash flow forecasting and commitment pacing report

Learn how to use IRR and public market equivalents to evaluate fund performance
Read our blog: What is the difference between IRR and PME?
 

Find out how PitchBook can help simplify your valuation workflow by checking out our full suite of valuation tools.
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Update: This article originally had a calculation error that has been corrected