Guide · Savings & Investing
Discounted Cash Flow: How to Value an Investment Using Future Cash Flows
A pound today is worth more than a pound tomorrow. Discounted cash flow (DCF) analysis turns that simple truth into a rigorous framework for valuing any asset that generates future cash — businesses, property, and long-term investments alike.
The core idea: money has a time value
If someone offers you £100 today or £100 in five years, you take the £100 today. Invested at a modest 8%, £100 today becomes £147 in five years. Conversely, a promise of £100 in five years is only worth about £68 today at that rate. DCF formalises this by discounting all future cash flows back to their present value using a chosen discount rate.
DCF formula
DCF = CF₁/(1+r)¹ + CF₂/(1+r)² + … + CFₙ/(1+r)ⁿ
CF = free cash flow in each year · r = discount rate · n = number of years
The discount rate r is the required annual return, reflecting both the risk-free rate (roughly the yield on government bonds) and a risk premium for the uncertainty of the specific investment. A safe, predictable business might use 8%; a high-growth technology startup might use 20% or more.
A worked example: valuing a small business
Consider a small UK business generating £50,000 of free cash flow per year, growing at 3% annually. Using a 10% discount rate, the table below shows the present value of each year's cash flow plus a terminal value — a single figure capturing all cash flows beyond year 5.
| Year | Free cash flow | Discount factor | Present value |
|---|---|---|---|
| 1 | £51,500 | 0.909 | £46,818 |
| 2 | £53,045 | 0.826 | £43,815 |
| 3 | £54,636 | 0.751 | £41,042 |
| 4 | £56,275 | 0.683 | £38,436 |
| 5 | £57,963 | 0.621 | £35,993 |
| Terminal value | £875,000 | 0.621 | £543,375 |
| Intrinsic value | ~£749,479 |
The terminal value uses the Gordon Growth Model: £57,963 × 1.03 ÷ (0.10 − 0.03) = £853,000, discounted back 5 years. If the business is available to purchase for £500,000, the DCF suggests it may be undervalued; at £900,000 it appears overvalued at this discount rate.
Why the discount rate is everything
The most dangerous thing about DCF is how sensitive the result is to the discount rate. A difference of just 2 percentage points can change the estimated intrinsic value by 30–50%. The same business above at different rates:
This is not a bug — it accurately reflects the reality that small differences in required return (which themselves reflect risk assessment) translate into large differences in what you should pay today for tomorrow's cash. The practical response is to run a range of scenarios and avoid paying prices that only look attractive under optimistic assumptions.
When DCF works — and when it does not
DCF is most powerful when applied to assets with predictable, long-term cash flows:
- Established businesses — A mature company with stable margins and a predictable growth rate is well-suited to DCF. Warren Buffett's approach to valuing businesses like Coca-Cola or See's Candies follows this logic.
- Investment property — Rental income provides concrete annual cash flows. DCF can value a buy-to-let property by discounting projected net rents plus expected sale proceeds, giving a maximum justifiable purchase price.
- Infrastructure and utilities — Long-duration contracts and regulated returns make cash flows highly predictable, which makes DCF reliable.
DCF is poorly suited to assets without predictable cash flows. Gold and most commodities produce no income, so there is nothing to discount — you are purely speculating on price. Early-stage startups may have plausible but highly uncertain future revenues, making the output extremely sensitive to assumptions. Short-term trading decisions are better evaluated on momentum and market microstructure than on intrinsic value from DCF.
Frequently asked questions
What discount rate should I use?
For businesses, the standard discount rate is the weighted average cost of capital (WACC) — the blended cost of equity and debt financing. For a typical small UK business this might be 8–12%. For personal investments, many analysts use the rate of return they could realistically achieve in an alternative investment of similar risk — often 8–10% for equity-like assets. Higher-risk businesses warrant higher discount rates. A startup might use 20–30% to reflect uncertainty; a mature utility might use 6–8%. The discount rate is the single most sensitive input in a DCF, so using a range rather than one number is advisable.
What is the terminal value in a DCF?
Most DCF models only forecast cash flows for 5–10 years explicitly. The terminal value captures all cash flows beyond that horizon as a single lump sum. The most common method is the Gordon Growth Model: Terminal Value = Final Year FCF × (1 + g) ÷ (r − g), where g is the long-run growth rate (often 2–3%, close to GDP growth) and r is the discount rate. The terminal value often accounts for 60–80% of a DCF's total estimated value, which is why small changes in g or r have such a large effect on the output.
Why do small changes in assumptions change the result so much?
Because of compounding in reverse. Discounting £1 ten years at 10% gives a present value of 39p. At 8% it gives 46p — a 18% difference from a 2-point rate change. Over 20-year forecasts and especially in the terminal value, even a 1% change in the discount rate or growth rate can change the total estimated value by 30–50%. This is not a flaw in DCF — it accurately reflects that long-term forecasts are inherently uncertain. The lesson is to run multiple scenarios rather than trusting a single-point estimate.
Is DCF used by professional investors?
Yes — DCF is the most widely taught and used valuation method in professional finance. Investment banks use it to advise on M&A transactions. Fund managers use it to assess whether a stock is above or below its intrinsic value. Warren Buffett has described his investment process in DCF-like terms, looking for businesses whose future cash flows, when discounted at a reasonable rate, indicate the shares are trading at a significant discount to intrinsic value. The challenge is not the maths but the quality of the underlying assumptions, which is why experienced analysts spend most of their time on the business model rather than the spreadsheet.