Short answer: Discounted cash flow (DCF) estimates what an investment is worth today by discounting its expected future cash flows back to the present. To value a business, an analyst forecasts the free cash flow the firm will generate, discounts each year’s figure at the firm’s cost of capital, and adds a terminal value for the period after the forecast ends.
Last reviewed: 4 November 2026
At a glance
| Term | Plain meaning | Role in a business valuation |
|---|---|---|
| Time value of money | A rupee today is worth more than a rupee later | Explains why future cash is discounted |
| Free cash flow | Cash left after operating costs, capital spending and working capital investment | The cash figure that gets discounted |
| WACC | Weighted average cost of capital, the average return a firm must give its financiers | Usually the discount rate |
| Terminal value | The worth of the business after the forecast period | Captures value beyond the explicit forecast |
| Net present value (NPV) | Discounted cash flows minus the initial outlay | Shows whether the value exceeds the cost |
Why is a rupee today worth more than a rupee later?
DCF rests on the time value of money, the idea that a rupee available now is worth more than a rupee received later. The reason is that the rupee you have today can be invested to earn a return. A rupee due in five years has lost those five years of possible earnings.
Discounting is the process of reversing this effect. It shrinks future amounts by a rate that reflects the return you could otherwise earn, so that all cash flows are expressed in today’s terms.
What is free cash flow?
Free cash flow is the figure DCF discounts. It is what remains after you subtract operating expenses, capital expenditure and working capital investment from cash inflows. Capital expenditure means money spent on long-lived assets such as machinery or buildings. Working capital investment is cash tied up in day-to-day items such as inventory and receivables.
Free cash flow is a measure of cash, not accounting profit. A firm can report a profit and still have little free cash flow if it is spending heavily on equipment or waiting to collect payments.
Which discount rate is used for a business?
In a business valuation, the discount rate is the weighted average cost of capital (WACC). WACC reflects the average return a firm must give the people who finance it, including lenders and shareholders. A higher WACC shrinks the present value of each future rupee, so the same forecast produces a lower valuation.
The rate is an estimate, and small changes to it can move the result considerably. This sensitivity is one of the main points where DCF valuations differ between analysts.
How is the value beyond the forecast counted?
Forecasting cash flows far into the future is hard, so DCF adds a terminal value. This captures the business’s worth after the explicit forecast period ends. It is usually based on a perpetual growth rate, which assumes cash flows keep growing at a fixed rate forever, or on an exit multiple, which applies a multiple to the final year’s figure.
The terminal value often makes up a large share of the total. This is a catch worth knowing: if most of the valuation sits in assumptions about distant years, small changes to the growth rate or multiple can change the answer substantially.
How do you read the net present value?
Net present value (NPV) is the sum of all discounted cash flows minus the initial outlay, which is the amount spent to acquire or start the investment. A positive NPV, meaning the discounted cash flows exceed the outlay, suggests the investment is worthwhile. A negative NPV signals a likely loss.
Worked example: a hypothetical business
The figures below are invented for illustration and do not describe any real company.
Suppose a business needs an initial outlay of ₹4.5 crore and is expected to generate free cash flow of ₹2 crore a year for three years. Assume a discount rate of 10 per cent and no terminal value, to keep the arithmetic simple.
- Year 1: ₹2 crore ÷ 1.10 = ₹1.82 crore
- Year 2: ₹2 crore ÷ 1.21 = ₹1.65 crore
- Year 3: ₹2 crore ÷ 1.331 = ₹1.50 crore
- Total discounted cash flow: about ₹4.97 crore
The NPV is ₹4.97 crore minus ₹4.5 crore, which is about ₹47 lakh. Under the rule above, the result is positive. If the outlay were ₹5 crore instead, the NPV would be slightly negative, which is a reminder of how close the answer can sit to zero.
What are the risks and catches?
DCF is only as reliable as its inputs. Free cash flow forecasts, the WACC and the terminal value are all estimates, and a small change in any one can change the result. Two analysts using the same business can reach very different values by choosing different assumptions.
DCF can value a whole business, a project, a stock, a bond, real estate or equipment, provided its future cash flows can be forecast. It cannot be applied in a meaningful way where cash flows are impossible to predict. Where forecasts are weak, a DCF can look precise while resting on guesses.
Frequently asked questions
Is DCF the same as profit-based valuation?
No. DCF uses free cash flow, which measures cash left after operating costs, capital expenditure and working capital investment, not accounting profit. Its focus on cash is the reason it is used alongside other valuation methods.
Why does the discount rate matter so much?
The discount rate determines how much each future rupee is worth today. In a business valuation it is usually the weighted average cost of capital, which reflects the average return a firm must give its financiers.
What does a negative NPV mean?
A negative NPV means the discounted cash flows are less than the initial outlay. This signals a likely loss on the investment.
Sources and last check
Facts in this article were checked against the sources below on 4 November 2026. Rules and figures can change; check the primary source before acting.
- groww.in (broker education)
- dhan.co (broker education)
- icicidirect.com (broker education)
- upstox.com (broker education)
- zerodha.com (broker education)
This article is general information, not investment advice. MyFinanceBandhu is not a SEBI-registered investment adviser.
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