Every investment is ultimately a bet on future cash flows. Discounted Cash Flow (DCF) analysis makes that explicit: model the cash a business will generate over time, then discount those future cash flows back to today's value. The result is an intrinsic value estimate — what you think the company is actually worth, independent of what the market says today.
£100 received today is worth more than £100 received in five years, because today's £100 can be invested and grow. The discount rate quantifies this — it's the return you require to invest capital. A higher discount rate (riskier investment, higher opportunity cost) makes future cash flows less valuable in today's terms.
You expect to receive £200 in 5 years. Your required return (discount rate) is 10% per year.
Present Value = £200 ÷ (1.10)⁵ = £200 ÷ 1.61 = £124
That future £200 is only worth £124 to you today, given your required return. This is the core maths behind every valuation.
The DCF steps: (1) Project free cash flow for 5–10 years. (2) Estimate a terminal value — the value of all cash flows beyond the projection period, typically using a perpetuity growth formula. (3) Choose a discount rate (usually WACC — weighted average cost of capital). (4) Discount all cash flows back to present value. (5) Subtract net debt to get equity value, divide by shares to get intrinsic value per share.
DCF is sensitive to assumptions — tiny changes in growth rate or discount rate swing the value wildly. Comps provide a market reality check. Find similar companies and compare their EV/EBITDA, P/E, and P/S multiples. If your company trades at 8× EBITDA and peers trade at 12×, it looks cheap — or there's a reason the market discounts it.
Your DCF model will be wrong. The inputs are estimates; the future is uncertain. The margin of safety — Benjamin Graham's principle — means only buying at a significant discount to your intrinsic value estimate. If DCF says intrinsic value is £50 per share, a 30% margin of safety means only buying below £35. This buffer protects against modelling errors and unforeseen deterioration.
The terminal value problem: in most DCFs, 60–80% of the calculated value comes from the terminal value — a number based entirely on a perpetual growth assumption plugged into a formula. A 0.5% change in the terminal growth rate changes the overall valuation by 20–30%. DCF is more useful for stress-testing assumptions and building conviction than for producing a single precise "correct" value. Treat the output as a range, not a number.
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