DCF Valuation

A discounted cash flow (DCF) model estimates what a company is worth today based on the cash it is expected to generate in the future. It is the most direct application of the principle that an asset is worth the present value of its future cash flows. A DCF forces analysts to make their assumptions explicit: how fast revenue grows, what margins look like, how much the company must reinvest and how risky the cash flows are. It is powerful but sensitive: small changes in assumptions can change the result a lot.

The steps#

1. Forecast free cash flow for an explicit period, usually 5 to 10 years. See Free Cash Flow.
2. Estimate a terminal value for all cash flows beyond the forecast period. See Terminal Value.
3. Choose a discount rate, usually the weighted average cost of capital (WACC). See WACC and Cost of Equity.
4. Discount all cash flows and the terminal value to today.
5. Calculate equity value by subtracting net debt from enterprise value.
6. Divide by shares to get value per share.
7. Test sensitivity to key assumptions.

enterprise value = Σ FCF_t / (1 + WACC)^t + terminal value / (1 + WACC)^n
equity value = enterprise value - net debt

Forecasting free cash flow to the firm#

FCFF = EBIT × (1 - tax rate) + depreciation - capex - change in working capital

Key drivers to forecast: revenue growth, operating margin, tax rate, reinvestment (capex and working capital). See Capex, Depreciation and Amortization and Working Capital.

Worked example#

Sensitivity analysis#

Because DCF outputs depend heavily on a few inputs, analysts show a table of values across a range of assumptions.

Moving WACC by one percentage point can change the value per share by 20% or more. Always present a range, not a single number.

Using DCF well#

• Tie forecasts to the business: market size, competitive position, reinvestment needs. See Competitive Advantage and Moats.
• Check implied multiples: does the terminal value imply a sensible EV/EBITDA?
• Run a reverse DCF: solve for the growth implied by today's price. See Valuation Basics.
• Use scenarios: bull, base and bear cases with probabilities.

Common mistakes#

• Overly optimistic growth for too long.
• Terminal growth above long term economic growth.
• Mismatched cash flows and discount rates: firm cash flows with WACC, equity cash flows with cost of equity.
• Ignoring stock based compensation and dilution.
• Forgetting net debt when moving from enterprise value to equity value.
• False precision: reporting a value to the cent.

Frequently asked questions#

What is a DCF valuation?#

A method that values a company by forecasting its future free cash flows and discounting them to today at a rate reflecting risk.

Why is terminal value so important in DCF?#

Because it often makes up the majority of the total value, so its assumptions strongly affect the result.

What discount rate is used in a DCF?#

Usually the weighted average cost of capital for free cash flow to the firm, or the cost of equity for cash flow to equity.

Next, learn how to estimate value beyond the forecast period in Terminal Value.