What is a discounted cash flow the discounted cash flow? Normally called the DCF for short is one of the two main valuation techniques used in banking. The multiples method approach is the other method commonly used. A DCF is quite versatile. And it's used to value an economic activity which generates a cash flow common examples are dividends coupons company returns debt instruments capex funded projects Etc. The list is endless. You could even use it in your personal capacity. For example, if you won the lottery and we're faced with option of a lump sum or a future set of payments a DCF can help you determine which is the better option. A DCF converts all forecast free cash flows to today's value using a discount rate. This discount rate reflects the time value of money the time value of money works on the presumption that money today is worth more than the same amount of money received at some point in the future as such the DCF is an intrinsic valuation methodology because it's based upon the present value of its future cash flows. Consequently a DCF is highly subjective as the discount rate is based on the modelers view of value. Although they are a number of conventions for building the discount rate. It still relies on the value as expectations of how the business will evolve. The model makes assumptions about growth rates margins investment levels small changes to assumptions and parameters can have significant effects on a DCF valuation. Now we have an understanding of what a DCF is let's explore its uses in further detail. A DCF is commonly used to calculate the Enterprise Value or EV of a company. The EV is important because it can be used in conjunction with the EV to equity bridge to determine the underlying share price. As you can see in the diagram equity is what remains of the EV after the net debt has been subtracted while the share price is the total value of the equity divided by the number of shares outstanding. So, how is a DCF calculated again? Let's recall a DCF takes a cash flow occurring in the future and calculates how much it's worth today. Imagine investing 100 today and you require return of 10% per time period Well at time period 0 your cash outflow is a hundred and that 10% return means that your investment is going to have to grow at that rate determining the amount requires multiplying that hundred by one plus 10% or 1.1. That means at time period one i.e one year from today. Our investment is expected to be 110. Then one year later after another 10% return. It's expected to be 121. And then at the end of year three which coincides with the end of this project. It's expected to be worth 133.1 and consequently this cash flow is expected to be paid to the investor after these three years at an annual compound rate of 10%. Great. But what happens in the reverse your offered 13 point one in three years time and you require a 10% return. How much should you pay now? Well, you have to start at year 3, you have to imagine that the cash flows coming to you 133.1 but that has to represent three years worth of a 10% return. So, how do I get back to the amount that I should invest today? Well, I need to divide by 1 plus my required return or divide by 1.1 in this example. So that means by year 2 it will be discounted to 121 by year 1 it's discounted to 110 and by year 0 or time period 0 it's 100 and that's how much I would pay now in order to secure a cash flow of 133.1 in 3 years time. Assuming I require 10% return. This 10% is the discount rate which takes the future cash flows and present values them or discounts them to today. Now the investors 10% required return also represents a cost of capital of 10% for the company being invested in of course, the investors getting a 10% return but the company is having to pay that out as extra money. It's a cost to them and we call that the cost of capital companies typically source cash from a variety of different places. They may have equity investments, but they also might have borrowed from a bank or taken on debt in a number of other ways such as issuing a bond a weighted average cost of capital or WACC is calculated as the average return required by the company to keep both debt and equity investors happy and that WACC is the average cost of capital to the company or the average required return from all the investors.