Discounted Cash Flow
Discounted cash flow (DCF) is a valuation method that estimates the present value of an investment by projecting its future cash flows and discounting them back to today using an appropriate rate of return.
The discounted cash flow model rests on a simple but profound insight: a dollar received in the future is worth less than a dollar received today, because today's dollar can be invested and grow. The discount rate captures this time value of money as well as the risk that future cash flows may not materialize as expected. By summing the discounted value of all projected future cash flows, the DCF gives an estimate of what an investment is worth today.
A typical DCF for a large U.S. company like Amazon involves several steps. First, analysts project free cash flow for 5-10 years, drawing on revenue growth assumptions, margin trajectory, and capex requirements. Second, they calculate a terminal value that represents the present value of all cash flows beyond the projection period, usually by applying a terminal growth rate (often 2-3%, close to long-run nominal GDP growth) and the Gordon Growth Model. Third, both the projected cash flows and the terminal value are discounted at the weighted average cost of capital (WACC). The terminal value typically represents 60-80% of the total DCF value, which highlights how sensitive the output is to the terminal growth and discount rate assumptions.
WACC is the blended cost of financing the business, weighing the cost of equity (estimated using the Capital Asset Pricing Model, or CAPM) by the equity share of the capital structure, and the after-tax cost of debt by the debt share. For a company like Apple with minimal net debt, WACC is essentially the cost of equity. For a highly leveraged company like a cable operator, the lower after-tax cost of debt meaningfully reduces WACC, boosting DCF value.
DCF models are notoriously sensitive to input assumptions. Changing the WACC from 9% to 10% for a 10-year cash flow projection can reduce the estimated value by 10-15%; changing the terminal growth rate from 3% to 2% can reduce it further. This sensitivity is both a feature and a bug. The model forces the analyst to be explicit about assumptions and test them, but it also means that a DCF can be reverse-engineered to 'justify' virtually any price with the right inputs.
In practice, most Wall Street analysts use DCF as one of several valuation methodologies, triangulating with comparable company multiples (EV/EBITDA, P/E) and precedent transaction analysis. No single method is definitive; the goal is for multiple approaches to converge on a similar value range, providing confidence in the conclusion.