What is Discounted Cash Flow (DCF)?
Discounted Cash Flow (DCF) is a valuation method that estimates the value of an investment, project, or company by projecting its expected future cash flows and discounting them to today’s value using a required rate of return (typically the weighted average cost of capital). The sum of discounted cash flows equals the present-value estimate of the asset.
How It Works
- Forecast free cash flows over an explicit period (typically 5 to 10 years).
- Estimate terminal value using a growth model or exit multiple.
- Choose a discount rate (WACC for the firm; cost of equity for equity-only DCF).
- Discount each year’s cash flow back to year zero.
- Sum the discounted explicit-period flows plus the discounted terminal value.
Saudi Context
Saudi investment banks, advisory firms, and PIF investment teams rely on DCF for M&A, IPO, and project valuations. Saudi WACC inputs typically use a SAR risk-free rate (10-year SAR government sukuk yield), a Saudi equity risk premium, and a beta from Tadawul comparables. CMA-regulated valuation reports for related-party transactions must document DCF assumptions thoroughly.
Example
A project generates SAR 5m, 6m, 7m, 8m, 9m of free cash flow over five years and a terminal value of SAR 80m. At a 10% WACC, the discounted values sum to SAR 76 million. If the project costs SAR 60 million, NPV = SAR 16 million (positive), supporting investment.