Discounted cash flow
DCFValuing a business on the cash it is expected to generate, discounted back to today at a rate reflecting its risk.
Also written: DCF
A DCF says a business is worth the cash it will produce, adjusted for the fact that cash arriving later is worth less than cash arriving now. Forecast the free cash flows explicitly for some years, capture everything beyond that in a terminal value, discount both at the cost of capital, and sum.
It is the only intrinsic method in the standard set. Comps and precedents both price the business against what someone else is paying; a DCF depends only on your own assumptions. That is its great strength, since it is the one method that can catch the market being wrong, and its great weakness, since it can be quietly wrong for a hundred slides without anyone noticing.
Its output is extremely sensitive to two inputs, the discount rate and the terminal value assumptions, which is exactly why interviewers press on those more than any other part of it. Terminal value routinely accounts for two thirds or more of the total, so most of the answer is an assumption about a period nobody actually forecast.
The standard construction is unlevered: discount unlevered free cash flow at WACC to get enterprise value, then bridge to equity value. A levered DCF discounting cash flows to equity at the cost of equity is possible but rarer, and mixing the two is the most common structural error.
Worked example
Five forecast years of unlevered free cash flow discounted at a 9% WACC give a present value of 240. The terminal value discounted back adds 615.
Enterprise value is 855, and after 200 of net debt, equity value is 655.
Note that 72% of the answer sits in the terminal value. Most of a DCF is an assumption about a period nobody forecast, which is why the growth rate and discount rate get tested hardest.