Multiples tell you what a stock costs relative to others. A discounted cash flow (DCF) tries to answer a deeper question: what is the business actually worth, from scratch? The idea is elegant — and you can grasp it without touching the algebra.
A business is its future cash
A company is worth the cash it will hand its owners over its lifetime. So to value it, you estimate the free cash flow it will produce each year into the future. That’s step one — and it’s mostly judgement about growth, margins, and competition.
A future dollar is worth less than today’s
Here’s the key move. A dollar arriving in five years is worth less to you than a dollar today, for two reasons: you could have invested today’s dollar, and the future is uncertain. So each future year’s cash is discounted back to its value in today’s money. The further out the cash, and the higher the discount rate (which reflects risk), the more it shrinks — as the diagram shows.
Add up all those discounted future cash flows — including a terminal value that stands in for everything beyond the forecast — and you get an estimate of intrinsic value. Compare it to the market price: trading well below could mean opportunity; well above, caution.
Garbage in, garbage out
A DCF feels precise — it spits out an exact number — but it’s only as good as its assumptions. Small tweaks to the growth rate or discount rate swing the answer wildly. Treat the output as a range and a way to make your assumptions explicit, not a verdict carved in stone. Its real value is forcing you to ask: what has to be true for this price to make sense?
Worked example
Say a business will produce $100 of free cash flow each year, and you use a 10% discount rate. Each future $100 is worth less today:
- Year 1: $100 ÷ 1.10 = $90.91
- Year 2: $100 ÷ 1.10² = $82.64
- Year 3: $100 ÷ 1.10³ = $75.13
The same $100 shrinks the further out it sits. Add those present values (and all the later years, plus a terminal value) and you’d get the company’s estimated worth. Notice how much the discount rate matters: at 5% instead of 10%, year 3’s $100 is worth $86.38, not $75.13 — a small rate change swings the valuation a lot.
The takeaway
A DCF values a company as the sum of its future free cash flows, discounted to today. The intuition — future cash is worth less now, and far-off cash much less — matters more than the maths. Respect it, but never trust it blindly. (This is education, not investment advice.)