In one sentenceA method for estimating the value of a business or project by adding up the present values of its expected future cash flows, discounted at a rate that reflects their risk.
Simply put
A business is worth the cash it will generate in the future, not what is in its books. So you forecast the free cash flow for each year, then discount it to today at the cost of capital and add it up.
The result is very sensitive to assumptions: a small change in the growth rate or discount rate changes the value a lot, so always present it with a sensitivity analysis.
Worked example
A simplified valuation of a project expected to generate free cash flow of 110,000 SAR in the first year, 121,000 in the second, and 133,100 in the third, at a discount rate of 10% and with no terminal value.
First year110,000 ÷ 1.1 = 100,000 SAR
Second year121,000 ÷ 1.21 = 100,000 SAR
Third year133,100 ÷ 1.331 = 100,000 SAR
Estimated value = sum of the present values300,000 SAR
Formula: Sum of (year's free cash flow ÷ (1 + discount rate)^year number) + present value of the terminal value
Don't confuse it with
Net present valueIt subtracts the investment cost from the present value to judge whether a decision is feasible, while valuation estimates the value of the business or project itself.