 Discounted cash flow method is a simple technique that is used to calculate valuations based on free cash flow projections. Discounted cash flow or discounting mode generally is also used in the venture capital method. Let's take a look at what discounted cash flow analysis means. So first we need to understand what the free cash flow here is. So this example comes from Rinnan-Helman book. They have the workhorse company that they use as an example. The company is making losses initially and then it turns into profits on the fourth year of its existence and then starts to grow more profitable. This is a very common scenario. Typically when you start a company you are not profitable initially because it takes time to acquire customers and you have product development and other things that incur costs. So the costs can be greater than the revenue so it's pretty common. The idea of discounting is that when we invest in the discounted company we need to get a profit from our investment. At least we should get as much money as we get from government bonds. Nowadays government bonds don't really produce any profits but quite commonly in older textbooks the risk-re-return rate which you would get from government bonds is set to be somewhere between 3 and 5%. So if we get 5% per year from government bonds that are risk-free then we should get more revenue, more money from this company that is more risky than the government bonds. So that's the idea. We need to take the risk into account. So the money in the future is actually less than the money now because if we buy a share of company now and we don't take into consideration that we could have invested our money elsewhere and gotten the 5% risk-free return then the next year we could have actually made the same investment and we would have gotten 5% more of the company. So we need to discount the future values to the current time taking into consideration the risk and the opportunity cost that we have when we invest the money into this company compared to some other companies. So we have calculated the cash flow projection somehow and then we calculate the discount factor. Here the discount rate is assumed to be 15% so let's assume that there is 5% risk-free rate and 10% premium for risk and how we get the discount factors here is that after first year, so this investment is made in 2019, so after the first year we should have 15% more if we don't then the investment does not worth it and at the second year, we should have 15% twice so 15% and then 15% more so we raise 15% of the second power and that gives us the discount factor. We have the discount factor grows exponentially or it decreases to zero if someone says that we will get a company that is worth a million euros but you will get the money in 50 years. I for example wouldn't take it because I value the money now more than I value a million euros in 50 years. So we value the future money less and less because there is risk involved and also we could be doing something else with the money than just sitting it on the bank account of this company. Then finally we have terminal value. The idea of cash flow projections is that we don't do that for the full future so we could go endlessly using this kind of discounting cash flow but at some point the projections become really uncertain and if you are projecting more than 5 years from now then calculating those projections would be difficult as well. So we assume that there is some kind of profitability at the end and some kind of growth rate and we use the profitability growth rate to calculate this terminal value. So the idea of this cash flow here is that this is the value that the company has produced us during the first five or six years and the terminal value is the value that the company will produce us from the sixth year on. And how the terminal value is calculated we basically use that kind of formula understanding what that formula where it's derived is not important but it's basically a formula for discounting from here to year infinity. So you discount on the infinity and that's the thing that you get when you derive it. One key thing to look at here is that if the growth rate of the company that we assume is higher than our discounted discounting rate then the company becomes infinitely valuable but that's not very realistic because there are limitations on how much companies can grow. At the end if a company grows on to be very large the general growth rate of the economy will set limits on how much they can grow. So in practice the growth rate can't exceed the discounting rate. Then we discount the terminal value we take a sum of all these discounted values and that's the net present value of the company or the valuation. So if we were to buy this company now we would have to buy pay six and a half million for it. So this is one way to calculate valuation you do cash flow predictions the free cash flows the amount of money that the company could return to the investors and then we discount those to the current values we take a sum of those current values and that gives us the value.