The Discounted Cash Flow Made Simple: How future cash flows become a value today (without the math headache)

Step 1: Go higher and higher — Company → Industry → Economy

So, now that we have discussed company-specific risks in detail—and we’ve talked about a forecast and a valuation—let’s connect the forecast to business value. How do we get there?

A discounted cash flow analysis. (I know… most people check out right here.) Especially the roughly 37% of us who detest math. So let’s break it down.

Step 2: Build the forecast (your crystal ball, but defensible)

As a refresher, a forecast is simply a prediction. However, in the valuation realm… meh… it’s a little more than that.

Yes, we predict the future (my crystal ball is top notch… wink), but we do it using the company’s past performance:
• Has revenue increased or declined?
• What has payroll cost, on average, over the last five years?
• How much have they spent each year buying new assets?

Then, we couple that with what we know is “semi-certain” (and I use that term loosely—tomorrow isn’t guaranteed). If the client knows insurance is going up next year, or they signed a new lease last week with better terms, we include that information.

So we lock down as much semi-certain information as we can about the company itself… then we zoom out:
• The local industry and market conditions
• The broader (national) economy
• And yes, even global factors that can affect costs, demand, and risk

Step 3: Forecast the cash flows — yes, ALL of them

Now we can get our crystal ball out and forecast the cash flows.

And when we say “future cash flows,” we mean ALL of them: the cash flow in 2027,
2028, 2029, 2030, 2031,… and so on until the end of time. Yes, forever. FOREVER forever.

A simple way to understand discounting

Here… let me ask you a question.

I’m a good friend of yours and we’ve known each other for 20 years. I have a booming business selling widget washers. Widget washers are the hottest thing on the market; everybody wants a widget washer.

If I came to you at 10pm on a Friday night and said:
“I’m making a deal right now and I’m short $20,000. If you give me $20,000 right now, I will give you $21,000 by 10pm on Saturday night—exactly 24 hours from now.”

You are receiving $21,000 in the FUTURE for investing $20,000 TODAY. That extra $1,000 is your reward for time and risk—what people often think of as the ‘discount.’

Now ask yourself: what could happen in 24 hours that would keep me from keeping my word? The risk is low… but it’s not zero.

Now, what if I said I’d pay you back in 24 months? You’d pause.

What if I said 24 years? Whew. The risk that something happens in 24 years is a whole different story: the company can change, the industry can change, the economy can change… the world can do world things.

Time creates risk. And the longer you wait for money, the less those future dollars are worth today.

Step 4: Bring future cash back to today (present value)

And that’s why, when we want the value TODAY (the present value), we have to discount those future cash flows.

But here’s the thing: doing a year-by-year discount calculation into infinity would take… well… forever. Like we’d be doing discounted cash flows in the afterlife. Hope heaven has Excel and a coffee maker.

So instead, we do two parts:
1) We forecast and discount the cash flows for a finite period—often the next 10 years (sometimes 5–10 depending on the situation).
2) Then we apply a formula called a perpetuity calculation to the final forecast year (often Year 10) to estimate the value of cash flows from Year 11 through ‘forever.’

That second piece is what valuation pros call the terminal value—basically the “everything after the forecast period” bucket.

So a DCF is simply:
• Present value of cash flows for Years 1–10
PLUS
• Present value of the terminal value (perpetuity / Year 11 to infinity)

Add those together and you arrive at an estimate of business value today using a discounted cash flow analysis.

Wrap-up: A professional forecast is more than a prediction

A forecast done by a professional is much more than simply a prediction of the future.

It’s a detailed, educated analysis supported by:
• Information and trends from the company’s past performance
• What we currently know about the company (your “semi-certain” facts)
• Data from the local industry (state), national, and global markets

The research is the hard part. Valuation professionals use many sources to back up their assumptions—so the math isn’t floating out there by itself.

In this scenario, you were having second thoughts over a $20,000 loan to your best friend. What if it were $20 million to a stranger? Who would you want preparing the forecast?

Next, we’ll talk about how valuation professionals determine how much each future cash flow gets discounted. Stick around.

Glossary of Business Terms & Concepts

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