Discounted Cash Flow Explained: The Formula, Step by Step

Discounted Cash Flow Explained: The Formula, Step by Step

What a DCF Actually Measures

A discounted cash flow model answers one question: what is a business worth today, given the cash it is able to hand its owner in future years?

The idea rests on a single principle. A dollar next year is worth less than a dollar today, because a dollar today can be invested and earn something. Discounting converts future cash into present terms so that all years can be compared on one scale.

It discounts cash flow, not profit. Accounting earnings include accruals, and depreciation is an allocation of a cost already paid, not this year's expense. Free cash flow — what remains after the business pays for the plant and equipment it needs to keep operating — is what actually reaches an owner.

The Formula

Value = sum of Cash Flow(t) / (1 + r)^t for years 1 to n, plus Terminal Value / (1 + r)^n

Three inputs decide everything:

Everything else in a DCF spreadsheet is decoration.

Step 1: Estimate Owner Earnings

Start from operating cash flow in the cash flow statement. Subtract capital expenditure. Strip out anything non-recurring. What remains is what an owner could withdraw without harming the business.

Buffett's own definition comes from the 1986 shareholder letter: net income plus depreciation and amortisation, less the capital expenditure required to fully maintain the business's long-term competitive position and unit volume. He called this owner earnings, and the operative word is maintain. Growth capex is optional spending; maintenance capex is not. Confusing the two is how most models overstate value.

Step 2: Choose a Discount Rate

The discount rate is not the return you would like to earn. It is the return you require given the risk you are taking.

Most practitioners use either the company's weighted average cost of capital or simply their own required return. Buffett has said he refers to long-term US Treasury yields rather than adding a risk premium for businesses whose earnings he considers highly predictable — an approach that may be defensible for him and is dangerous for anyone with less certainty about that input.

Two practical rules:

Step 3: Project the Explicit Years

Model five to ten years. Past roughly ten, year-specific guesses carry no information, and pretending otherwise is false precision rather than rigour.

Keep growth assumptions modest. A company cannot grow faster than the economy forever without becoming the economy, and the few that beat that rule are the exception that defines it.

Step 4: Terminal Value

A company does not stop existing in year ten. Terminal value captures everything after your explicit window, and in most models it accounts for the majority of the final figure — which should worry you.

The standard approach is the perpetuity formula:

Terminal Value = Final Year Cash Flow x (1 + g) / (r - g)

where g is perpetual growth. Keep g below long-run economic growth. Above roughly 3%, you are asserting that this business will outgrow the economy forever, and the formula will reward that assertion generously.

Because terminal value dominates, always compute it separately and check what share of the total it represents. Above roughly 70%, your valuation is mostly an assumption about a future you did not model.

Step 5: Subtract Net Debt

The DCF values the operating business — the enterprise. Equity holders get what is left after lenders are paid.

Equity Value = Enterprise Value - (Total Debt - Cash)

A Worked Illustration

The numbers below are illustrative arithmetic chosen to be easy to follow. They describe no real company.

Assume a business producing $100 of free cash flow, growing 5% a year, discounted at 10%, modelled over 5 years with terminal growth of 2%.

Year 1: 100 x 1.05 = 105, discounted 105 / 1.10 = 95.5

Year 2: 110.3, discounted 110.3 / 1.10^2 = 91.1

Year 3: 115.8, discounted = 87.0

Year 4: 121.6, discounted = 83.0

Year 5: 127.6, discounted = 79.2

Sum of discounted explicit years: approximately 436

Terminal value at year 5: 127.6 x 1.02 / (0.10 - 0.02) = 1,627, discounted back five years: 1,627 / 1.10^5 = 1,010

Enterprise value: approximately 1,446. Note that terminal value alone is about 70% of it — the model is mostly telling you what you assumed about the years you never wrote down.

Now change only the discount rate, from 10% to 12%. Everything else identical.

The explicit years fall to roughly 414, and terminal value to roughly 739. Enterprise value becomes approximately 1,153 — about 20% lower.

Two percentage points of discount rate moved the answer by a fifth. Nothing happened to the business. That is the honest lesson of the whole exercise, and it is why a single DCF output should never be treated as a price target.

What Breaks These Models

How to Actually Use One

Do not use a DCF to produce a target price to three decimal places. Run it backwards instead: take today's market price, solve for the growth the market is implying, and decide whether that implied growth is realistic. This is far harder to fool yourself with, because you are interrogating someone else's assumption rather than defending your own.

Then leave a margin of safety. A business estimated at X is not worth buying at X. The uncertainty the model cannot remove — driven mostly by inputs nobody can know — is exactly what the discount absorbs.

---

This article describes standard discounted cash flow methodology, including owner earnings as defined in the 1986 Berkshire Hathaway shareholder letter. All figures are illustrative arithmetic and describe no real company. It is educational material, not investment advice.