---
title: "What is Discounted Cash Flow?"
description: "Discounted cash flow helps investors decide how much to pay for an investment based on the money the company generates. Learn what discounted cash flow (DCF) means in 2025, how to calculate it, and why it’s essential for stock valuation in this step-by-step guide with examples."
canonical_url: https://trendshare.org/how-to-invest/what-is-discounted-cash-flow
markdown_url: https://trendshare.org/ai/what-is-discounted-cash-flow.md
published: 2013-11-23
last_updated: 2025-10-04
content_license: https://trendshare.org/about/disclaimer
---
# What is Discounted Cash Flow?
Source: https://trendshare.org/how-to-invest/what-is-discounted-cash-flow
Updated: 2025-10-04
How much should you pay for a stock? That depends on how much you want to
make! Obviously you want to buy at a low price and sell at a high price, but
what do "low" and "high" mean? Can you define them for a single stock? Can you
predict them?
All of [Trendshare's investment guide](/how-to-invest/) focuses
on [value investing](https://www.investopedia.com/terms/v/valueinvesting.asp)—finding stocks trading for less than [what the company will earn in the future](https://trendshare.org/how-to-invest/earnings-matter-most) makes
them worth. Earnings are important; the success of the underlying business
predicts the performance of the stock.
How do you get from earning potential to a working definition of value?
Start by calculating the return you want from your investments.
## What Does an Investment Return?
Suppose you buy a doughnut store for $100. (Maybe it's a little roadside
stand in the wilds of Canada, and that's why it's such a bargain.) Business is
good, but you hate getting up at 4 am, so you sell it a year later for $150.
You've made $50: a 50% return in a year.
Suppose you decide to buy a coffee stand and sleep in until 5 am. You find a
good candidate, and your sales projections suggest that you can probably flip it
next year for $300. That 50% return from last year was so great, you want to do
it again. Here comes some math: what do you need to spend right now to make 50%
when you sell next year for $300? In Algebra, that's `x * ( 1 * 0.5 ) =
300`, or `x = 300 / 1.5` or $200.
That math gives you a specific dollar amount. If you can hit those targets of
$200 and $300, you'll make made a very good return on your investment. Your
question is now "*Can* I sell this coffee stand for $300 next year?" If
so, it might be a good investment. In practice, you also must consider what it
costs to run the coffee stand, though if it'll be worth 50% more than what you
paid for it, it's probably a well-run business.
If it's plausible that the business will be worth that much next year and if
it's reasonable that you can sell it for that amount, you've found a wonderful
opportunity. If either of those is unlikely, you can move on to another
idea.
## What is Free Cash Flow?
In practice, the process is the same even if the numbers aren't that easy.
The question is still "how do know what a business is worth?". One way of
looking at that is to figure out how much money it produces.
[Free cash flow](https://trendshare.org/how-to-invest/what-is-free-cash-flow) is the amount of real
money a company makes for its owners—its shareholders. This money can be
reinvested in the business to help it grow, [paid out as dividends](https://trendshare.org/how-to-invest/why-do-companies-pay-dividends), used to buy
back stock, or put into play to buy other companies to expand the market,
customer base, or types of business.
This cash flow is different than profit. Profit is a year-by-year measurement
of what's left over after paying expenses. Free cash flow measures how much cash
the business generates. That could *become* profit if that makes sense,
but there's so much more a business can do with it.
There are several ways to measure business cash flow, but by the simple and
useful definition, free cash flow is the amount of cash a business has after it
pays for its standard upkeep and expansion. Once your business has paid what it
needs to pay to stay in business (or build other doughnut carts), what's left
over is free cash.
"Real cash", of course, means that you can't count anything in accounts
receivable until you actually have the money in hand. Similarly, anything where
accounting might let you declare the value of an asset but you can't actually
use that asset to pay a bill or send a check to a shareholder or buy something
else right now doesn't count. This is truly cash in hand.
[Free cash flow is one of the best measurements of business success](https://www.investopedia.com/articles/fundamental-analysis/09/free-cash-flow-yield.asp) in investing,
because it's tied the fundamental performance of the business. You may hear of
EBIDTA, OEBIDTA, and other accounting terms, but when it comes time to write
checks to vendors and pay employees, there's nothing better than money in the
bank. That's what makes free cash flow such a great measure of the value and
growth of a business.
Put in simple terms: if you buy that coffee shop for $200 now and it reliably
generates $100 in free cash every year, you can expect to make a *150%*
return on your investment in two years. That's because if you sell the coffee
shop for $300 in two years, you'll have made $100 in free cash each year for two
years, plus the $200 you initially invested.
## What is Discounted Cash Flow? (why free cash is worth paying for!)
How does cash flow relate to an investment's price? You have to correlate the
money you expect a business to generate to the return you want to achieve from
owning that investment.
*Discounted cash flow* is the present value of the free cash an
investment can generate. The amount you invested plus the percentage rate of
return you want equals the price you have to sell it for. That works great if
you know the amount you invested and the return you want to get, but what if
you're trying to figure out the right price to *pay*?
In other words, how much do you want to pay right now to make $100 every year
with your Canadian coffee stand?
If you know two of the three values, you can figure out the other with a
little algebra. Suppose you have the opportunity to buy a cupcake shop (where
you can sleep until 10 am and then start making cupcakes for happy hour) now and
think you can plausibly sell it next year for $600. If you want to make another
50% return on your investment in a year, you can figure out how much you want to
spend on it right now. The right price times 1.5 (or plus 50%) equals $600, so
$600 divided by 1.5 equals the right price right now. If you pay no more than
$400 now, you can meet your goal.
Why a 50% return? Ask yourself this: how much would you pay right now to get
$600 next year? If you pay more than $600, that's silly. If you pay less, you're
making money. How much money do you want to make, especially compared to other
potential investments?
In other words, you've figured out what you want to pay based on how much
you want to make, just like with the coffee shop and the doughnut shop.
In more technical terms, discounted cash flow analysis lets you calculate the
present value of an investment based on its expected future cash flows. You make
a *discount* to the price to account for your desired return.
This works regardless of whether the free cash gets returned to you or
reinvested. Either way it produces value year after year against your initial
investment!
## Growth is Worth Paying For (Present Value)
In all of the examples (doughnut stand, coffee stand, cupcake shop), the
underlying business grew in value over time. If you can predict that growth
rate with sufficient accuracy, you can figure out what the business is worth
right now if you have a time frame for selling it.
The *present value* of an investment is the price you should pay for
the investment given its expected growth rate.
If you expect your doughnut stand to be worth $200 next year and you want to
make 50% in a year, you can pay no more than $100 for it right now. Given a
time frame of one year and your expected rate of return, the present value of
the business is $100. If it costs you more than that, it's not a bargain. If it
costs you less, it's on sale.
In real life, discounts are rarely this step. Yet with all of the stocks on
the market now, opportunities do happen. Over a period of decades, the [S&P 500 index fund](https://trendshare.org/how-to-invest/buy-the-s&p-index-fund) returns somewhere
around 8% a year. That's the simplest buy-and-hold strategy you can pursue in
the stock market, and it's been reliable in the US for decades. If you take away
only one hot investment tip, it's this.
### Choosing a Discounted Cash Flow Rate in 2025
To beat the stock market you must earn more than 8% a year. Give yourself a
little bit of safety and look for 12%. To find a bargain in the stock market,
you want a discounted cash flow value of about 12%. (Trendshare uses 15% to
provide a more conservative [margin of safety](https://trendshare.org/how-to-invest/what-is-a-margin-of-safety).)
In other words, you need to pay no more than $178.57 for your doughnut stand
right now to be able to sell it next year for $200 and make a 12% return.
In the stock market in 2025, small cap stocks had a discount rate of 16%
while large cap stocks had a discount rate of 4%. (See [Morningstar 2025 stock analysis](https://www.morningstar.com/markets/q4-2025-stock-market-outlook-no-margin-error).)
## What is a Share of Any Stock Worth?
Put together all of these ideas. *Discounted cash flow analysis* is a
financial measurement which helps you answer the question "What should I pay
for a share of a company, given its cash flow situation and [the rate of return I want to get](https://trendshare.org/how-to-invest/what-is-a-good-annual-rate-of-return)?"
For a stock, the value of a share isn't exactly what you think you can sell
it for in the future. That's too difficult to predict, given that you're not
buying the business as a whole. If you buy a thousand shares of [General Motors](/stocks/GM/view), you'll own a fraction of a fraction
of the company. With stocks, you have to figure out what you think the business
may be worth in the future (which you already know how to do now) and then come
up with a fair price for it.
To figure out the value of GM in the future, you can use the amount of free
cash the company will generate for each share of stock. This assumes that the
value of each share of stock will eventually reflect a fair valuation of that
free cash flow, though it allows that the market can be irrational at times.
The interplay between these two trends provides value investors with the
opportunity to find bargains!
This math *does* get a little bit more complicated, but you don't
have to understand all of the details if you understand the goal. $100 invested
at a 50% rate of return will give you $150 next year. If you know something
worth $150 next year and you want to make a 50% return, you can pay no more
than $100 for it right now.
## How to Calculate Discounted Cash Flow
Because of the volatility of the stock market and the unpredictability of
cash flow (see [Free Cash Flow Jitter](https://trendshare.org/how-to-invest/what-is-free-cash-flow-jitter) for a measurement of the reliability of a company), you want to add
a measure of risk insurance to your calculations. By discounting the final
price, you give yourself a margin of error. If there's a 10% risk that the
cupcake shop *won't* be worth $600 next year, take 10% off the $400
price and resolve to pay no more than $360 for it.
In practice, this means find a good stock you like. Make sure it has
reliable cash flow and a good market position. Determine the likelihood that
the company will stick around and do good things. Calculate the cash flow out
five or ten years, taking into account the past five or ten years of cash flow
or owner earnings.
Choose your discount rate and figure out the present value of the company
based on its expected cash flow. Apply your margin of safety.
You now have a target number. If the stock price is at or below that number,
it's probably on sale. Keep investigating until you're comfortable investing.
Otherwise, move on. Then, buy and hold.
## What are the Common Mistakes and Limitations of Discounted Cash Flow?
Apart from some middle school algebra which gets easier once you've done it
a few times, nothing here is rocket surgery. You do need to keep in mind a few
limitations, however.
- You'll have to skim the accounting statements (10-Ks and 10-Qs) of public companies to figure out free cash. (Or use a service like Trendshare to do it for you.) None of this is complicated, but you're dealing with rough figures that can hide a lot of details. Remember that your figures need to be in the ballpark of correct.
- The present value calculation depends on the return *you* want to get. If investor sentiment is happy enough with 4% returns for your stock and your calculations expect a 20% return, you may wait a long time to find the appropriate discount.
- The margin of safety protects against irrational exuberance and (some) errors of judgment in predicting the future. It won't protect you against everything.
- Stocks go up and stocks go down. Stocks may be underpriced for a long time, drop in value further, and reach their fair value in years or decades. Patience and caution are the order of the day.
Even with these disclaimers, the value of discounted cash flow is that it
reflects the underlying value of the business, it respects the price you want
to pay, and it gives you a range of prices where your certainty or uncertainty
can guide your choices.
Congratulations! You're a [value investor](https://trendshare.org/how-to-invest/what-is-value-investing).
**Diagram:** Discounted Cash Flow (DCF) estimates the present value of future cash flows by applying a discount rate.