Discounted cash flow — the intuition

Discounted cash flow (DCF) is the most fundamental valuation method: a business is worth the cash it will generate for owners in the future, with future cash converted to today's terms.

Why future cash is worth less

A dollar next year is worth less than a dollar today — you could invest today's dollar and earn a return, and the future is uncertain. We shrink future amounts back to the present using a discount rate, a process called discounting.

Present value = Future cash flow / (1 + r) ^ n

Here r is the discount rate (your required annual return) and n is the number of years away.

A single-year example

Suppose you expect 100 of free cash flow one year from now and require a 10% return:

Present value = 100 / (1.10) ^ 1 = 90.9

That 100 a year out is worth only 90.9 to you today. Two years out:

Present value = 100 / (1.10) ^ 2 = 82.6

The whole idea in one sentence

A company's value is the sum of all its future free cash flows, each discounted back to today. Everything in the next lesson is just doing this sum carefully — projecting the cash flows, picking the rate, and adding them up. The discount rate is the single most powerful lever in the model, which is why we will treat it carefully.