DCF Valuation Explained: How Discounted Cash Flow Works, Step by Step
DCF (discounted cash flow) valuation estimates what a business is worth today from the cash it will generate in the future. You forecast free cash flow for about five years, estimate a terminal value for the years after, then discount everything back to the present using the WACC. That gives enterprise value. Subtract net debt to get equity value, then divide by shares for a value per share.
Key takeaways
- Value = the present value of future free cash flows.
- WACC is the discount rate for unlevered free cash flow.
- Terminal value often dominates, so test its assumptions hard.
- Always present a range (sensitivity table), never a single “true” number.
The DCF in six steps
1. Forecast unlevered free cash flow (UFCF)
UFCF = EBIT × (1 − tax rate) + depreciation & amortisation − capex − increase in net working capital
These numbers come straight from a three-statement model.
2. Estimate the discount rate (WACC)
WACC = (E / (D + E)) × cost of equity + (D / (D + E)) × cost of debt × (1 − tax rate)
- Cost of equity: often estimated with CAPM: risk-free rate + beta × equity risk premium.
- Cost of debt: the company’s borrowing rate, adjusted for tax.
3. Calculate terminal value
Two common methods:
- Perpetuity growth: TV = FCF in the final year × (1 + g) / (WACC − g), where g is a modest long-term growth rate, typically at or below long-run economic growth.
- Exit multiple: TV = final-year EBITDA × an appropriate EV/EBITDA multiple from comparable companies.
4. Discount to present value
Discount each year’s FCF and the terminal value: PV = cash flow / (1 + WACC)^t.
5. From enterprise value to equity value
Equity value = enterprise value − debt + cash (and other adjustments)
6. Per-share value and sensitivity
Divide by diluted shares. Then build a sensitivity table varying WACC and terminal growth (or exit multiple).
A worked illustration
| Year | 1 | 2 | 3 | 4 | 5 |
|---|---|---|---|---|---|
| Free cash flow ($m) | 10 | 11 | 12 | 13 | 14 |
| Discount factor at 10% | 0.909 | 0.826 | 0.751 | 0.683 | 0.621 |
| Present value ($m) | 9.1 | 9.1 | 9.0 | 8.9 | 8.7 |
Sum of PV of FCF ≈ $44.8m. Terminal value with 2.5% growth: 14 × 1.025 / (0.10 − 0.025) ≈ $191.3m. Its present value: 191.3 × 0.621 ≈ $118.8m. Enterprise value ≈ $163.6m, and terminal value is about 73% of it. That share is why its assumptions matter so much.
Illustrative numbers only.
Common DCF mistakes
- Growth rate in the terminal value above long-run economic growth. That implies the company eventually becomes larger than the economy.
- Mixing levered and unlevered cash flows and discount rates.
- Ignoring working capital in fast-growing companies.
- Over-precision: presenting “$27.43 per share” from assumptions that are guesses.
- No cross-check against trading or transaction multiples.
Where DCF skills are used
Equity research, investment banking, corporate development, private equity, and valuation work for startups and fundraises. Excel speed matters; see Excel skills for finance jobs. The modelling foundations are in what is financial modelling?, and credentials for these careers are compared in finance and business certifications compared.
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Sources
Frequently asked questions
What is a DCF in simple terms? +
A discounted cash flow valuation estimates what a business is worth today by forecasting the cash it will generate in future and converting that future cash into today's money using a discount rate that reflects risk and the time value of money.
What discount rate is used in a DCF? +
For unlevered free cash flow, the weighted average cost of capital (WACC), which blends the cost of equity (often estimated with CAPM) and the after-tax cost of debt according to the company's capital structure.
Why is terminal value so important? +
Because it often represents a large share of total value, frequently more than half. Small changes to the long-term growth rate or exit multiple can move the valuation dramatically, which is why sensitivity tables are essential.
What are the limitations of DCF? +
It depends heavily on assumptions that are hard to predict, such as growth, margins, discount rate and terminal value. It works best for businesses with predictable cash flows, and should be cross-checked with comparable company and transaction multiples.
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