# DCF Valuation

> A DCF values a company by forecasting free cash flows and discounting them to today. Learn the steps, a worked example, sensitivity analysis and common mistakes.

Source: https://learn.tradelabsai.com/fundamentals/dcf-valuation/  
Track: Fundamental Analysis · Level: Intermediate · Updated: 2026-10-03  
Publisher: TradeLabs AI (https://tradelabsai.com). Education, not financial advice.  
Cite as: TradeLabs Learn, "DCF Valuation", https://learn.tradelabsai.com/fundamentals/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](https://learn.tradelabsai.com/fundamentals/free-cash-flow/).
2. **Estimate a terminal value** for all cash flows beyond the forecast period. See [Terminal Value](https://learn.tradelabsai.com/fundamentals/terminal-value/).
3. **Choose a discount rate,** usually the weighted average cost of capital (WACC). See [WACC and Cost of Equity](https://learn.tradelabsai.com/fundamentals/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](https://learn.tradelabsai.com/fundamentals/capex/) and [Working Capital](https://learn.tradelabsai.com/fundamentals/working-capital/).

## Worked example

**Example: A simple five year DCF**
A company has FCF of $100 million this year, expected to grow 8% a year for five years, then 2.5% forever. WACC is 9%. Net debt is $300 million; there are 50 million shares.

| Year | FCF ($m) | Discount factor at 9% | Present value ($m) |
|---|---|---|---|
| 1 | 108.0 | 0.917 | 99.1 |
| 2 | 116.6 | 0.842 | 98.2 |
| 3 | 126.0 | 0.772 | 97.3 |
| 4 | 136.0 | 0.708 | 96.4 |
| 5 | 146.9 | 0.650 | 95.5 |

Sum of present values ≈ $486 million.
Terminal value at year 5 = 146.9 × 1.025 / (0.09 minus 0.025) ≈ $2,317 million. Present value ≈ 2,317 × 0.650 ≈ $1,506 million.
Enterprise value ≈ 486 + 1,506 = $1,992 million.
Equity value ≈ 1,992 minus 300 = $1,692 million, or about $33.8 per share.

Note that about 76% of the value comes from the terminal value.

## Sensitivity analysis

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

| WACC \ terminal growth | 2.0% | 2.5% | 3.0% |
|---|---|---|---|
| 8% | Higher | Higher | Highest |
| 9% | About $32 | About $34 | About $36 |
| 10% | Lower | Lower | Lower |

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](https://learn.tradelabsai.com/fundamentals/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](https://learn.tradelabsai.com/fundamentals/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](https://learn.tradelabsai.com/fundamentals/terminal-value/).

## Continue learning

- Next lesson: [Terminal Value](https://learn.tradelabsai.com/fundamentals/terminal-value/)
- Previous lesson: [Free Cash Flow Yield and Dividend Yield](https://learn.tradelabsai.com/fundamentals/dividend-yield/)
- Related: [Free Cash Flow Yield and Dividend Yield](https://learn.tradelabsai.com/fundamentals/dividend-yield/): Dividend yield is the annual dividend divided by the share price. Learn the formula, payout and coverage ratios, dividend growth and how to avoid yield traps.
- Related: [Terminal Value](https://learn.tradelabsai.com/fundamentals/terminal-value/): Terminal value captures a company's worth beyond the forecast period. Learn the Gordon growth and exit multiple methods, with examples and sanity checks.
- Related: [WACC and Cost of Equity](https://learn.tradelabsai.com/fundamentals/wacc-and-cost-of-equity/): WACC blends the cost of equity and the after tax cost of debt into a discount rate. Learn CAPM, beta, the equity risk premium, a worked example and common pitfalls.
- Related: [Free Cash Flow](https://learn.tradelabsai.com/fundamentals/free-cash-flow/): Free cash flow is cash left after running and investing in the business. Learn how to calculate FCF, FCF yield and conversion, and why investors value it highly.
- Related: [Time Value of Money](https://learn.tradelabsai.com/math/time-value-of-money/): A dollar today is worth more than a dollar tomorrow. Learn present and future value, discounting, annuities and NPV, the maths behind bonds, valuations and options.
- Related: [Valuation Basics](https://learn.tradelabsai.com/fundamentals/valuation-basics/): Valuation estimates what a business is worth. Learn intrinsic vs relative valuation, the main multiples, how growth and risk affect value and common mistakes.