Discounted Cash Flow (DCF) Method Explained
How future cash flows translate into value today
To understand the more advanced methods of startup valuation, we first need to look at one of the most widely used tools in professional investing: the Discounted Cash Flow (DCF) method. The DCF method estimates the value of a startup or mature company by analysing the cash it is expected to generate in the future.
In the section on discount rates and the present value of future money, we have seen that, when calculating interest income, the future value of a given amount increases with a growth factor (1 + r)n. But investors typically face a more practical question: what is the value today of multiple cash flows that will occur at different points in the future? These cash flows can come from many sources — for example annual profits, license income, subscription fees, or the revenue that a startup expects to generate once the product enters the market. Because these amounts rarely occur at one single moment but are spread out over months or years, investors need a method to bring all those future payments back to “today's money.” This is exactly where the DCF method becomes essential.
Using the present-value formula introduced earlier, we can calculate how much a future cash flow in period n is worth in “today's money,” namely:
So, this is the DCF method — the discounted cash flow method — and it is the most important valuation tool for any financial analyst. It is equally relevant for anyone trying to determine the value of an invention or early-stage startup, because the DCF relies on understanding the cash flows your project can realistically generate in the future. By discounting these future amounts, we can calculate what they are worth today, a calculation formalized in the concept of Net Present Value (NPV). In the next section, we'll walk through the steps and show how you can easily calculate an NPV yourself using nothing more than a simple spreadsheet.
Looking at the formula above, we see that there are a number of unknowns that we need to know before we can apply the formula, namely the cash flows (CF 0 to CF n ) and the discount rate r. We start with the latter.
Capital Asset Pricing Model and the discount rate r
So far, we have taken the discount rate, r, as interest and chosen it to make calculations easier. However, it becomes much more difficult to figure out what value to take for r when valuing a company. Before we proceed, we need to define what r actually represents.
We can illustrate this with the NPV formula. Suppose you receive two proposals.
Proposal 1 is to deposit $100 for five years in an account at a well-known bank on the corner of the street at an interest rate of 4%. So, you receive four interest payments of $4 each and a payment of $104 in year five ($4 + the invested amount, $100, also known as the principal).
Proposal 2 is to invest the same amount in a biotechnology company. In return, you receive $7 for four years and in year five, $107. Which proposal would you choose?
At first glance, this seems like an easy question to answer, and you're inclined to go with proposal 2; after all, you get more money for the same investment. But is this really the case, and how can we find out? The answer is provided by the Capital Asset Pricing Model (CAPM). CAPM is one of the most important cornerstones of finance and is used to calculate the required return for a specific investment in a particular project or company. It is calculated using the following formula:
where
- r i is the discount rate or required return, also known as cost of capital or expected return, for a specific investment, project, company, etc. We will use these terms interchangeably.
- R f is the risk-free rate.
- R m is the return of the (market) portfolio, and
- βi is the risk associated with a specific company, project i, etc.
In the following page about the Capital Asset Pricing Model (CAPM), we will continue to explore the question of whether you should put your money safely in the bank or invest in a risky biotechnology company. Think, for example, of Moderna in 2019 — a moonshot biotech company with no commercial product yet, huge R&D expenses, high uncertainty, and almost impossible to value with a classic DCF. As described in our Moderna example story, the company went from near-zero revenue to 19.2 billion U.S. dollars in 2022. Cases like Moderna show why the discount rate matters so much — and why investors demand a high expected return when the future is so uncertain.