The DCF method is one of the most commonly used valuation tools in investment banking. But understanding the theory is not enough — bankers are expected to know how to build a working DCF model that is accurate, structured, and ready for client review. This article focuses on the practical side: how to construct a DCF inside a financial model, how the components link together, and what standards are expected in professional settings.
Structuring the Model
A DCF model is not a standalone file — it sits on top of a full three-statement model or integrated forecasting engine. The output section of the model pulls projected free cash flows, discounts them using the WACC, and calculates enterprise value and equity value.
A clean DCF section typically follows this structure:
- A clearly labeled input area for WACC, terminal assumptions, and forecast years.
- A free cash flow table showing each projected year’s unlevered FCF.
- A terminal value calculation, shown below the last forecast year.
- A present value calculation for all projected flows and the terminal value.
- An equity value bridge, adjusting enterprise value for debt, cash, and other items.
- Optional sensitivity tables for WACC, terminal growth, or other key drivers.
Each step should be laid out in a separate, clearly labeled section — either on its own sheet or in a dedicated area below the main model outputs. The entire structure should be transparent, traceable, and easy to update as assumptions change.
Forecasting Free Cash Flows
The DCF model is built on projected free cash flows. In most banking models, this refers to unlevered free cash flow — the cash available to all capital providers before interest payments. It reflects the operating performance of the business, independent of capital structure.
Free cash flow is typically calculated as:
Free Cash Flow (Unlevered) =
- EBIT × (1 – Tax Rate)
- + Depreciation & Amortization
- – Capital Expenditures
- – Change in Net Working Capital
These components come directly from the forecasted income statement, balance sheet, and cash flow statement. That’s why a three-statement model must be fully linked and functional before building the DCF section.
The forecast period is usually 5 to 10 years. Each year’s free cash flow should appear as a separate line item, clearly labeled and tied to the core model. If the company operates in multiple business segments or geographies, FCF can be projected on a consolidated basis or broken out for each unit — depending on the purpose of the valuation.
Free cash flow projections should reflect realistic growth and investment needs. If capex is understated or working capital movements are ignored, the valuation will be misleading. A good model shows all assumptions clearly and links them to the outputs with clean formulas.
Calculating Terminal Value
Terminal value captures the value of a business beyond the explicit forecast period. In most DCF models, it accounts for the majority of the total valuation, so the method and assumptions used must be carefully chosen and clearly shown.
There are two standard methods for calculating terminal value:
1. Perpetuity Growth Method
Also known as the Gordon Growth Method, this approach assumes the company will continue to generate free cash flow indefinitely, growing at a constant rate. The formula is:
Terminal Value = Final Year FCF × (1 + g) / (WACC – g)
Where:
- g is the perpetual growth rate, usually between 1% and 3% for mature companies
- WACC is the discount rate used in the model
This method is common in intrinsic valuation when there is no expected exit event. The growth rate should be modest and aligned with long-term economic trends.
2. Exit Multiple Method
This approach assumes the company is sold at the end of the forecast period at a valuation multiple, such as EV/EBITDA or EV/EBIT. The formula is:
Terminal Value = Final Year Metric × Exit Multiple
The chosen multiple is typically based on comparable company analysis. This method is more common in private equity models and M&A, where a future exit or sale is expected.
Best Practice:
Both methods should be tested if possible. The model should allow users to toggle between them or run sensitivity analysis to show how each method affects the final valuation. Regardless of the approach, the terminal value should be clearly separated from the projected FCFs and discounted appropriately to present value.
Projection Horizon — How Many Years and Why
The projection horizon defines how many years of free cash flow are forecasted before terminal value takes over. In most investment banking models, this horizon ranges between five and ten years, depending on the company and context.
A shorter forecast period (e.g., five years) is typical for stable or mature businesses with predictable cash flows. It’s also common when limited information is available, or when a deal is time-sensitive and detailed projections beyond five years would be speculative.
Longer horizons (seven to ten years) may be used in cases where the company is still growing, undergoing major changes, or needs time to reach a steady state. This is often seen in DCFs used for internal planning, early-stage IPOs, or long-term infrastructure valuations.
The goal is to project until the business stabilizes — meaning margins, reinvestment, and growth assumptions level off and can reasonably support a terminal value calculation. Projecting too far out can add noise and uncertainty. Stopping too early can misstate long-term value.
Whatever the length, the model should show clearly where the explicit forecast ends and terminal value begins. Each year must have a full and consistent free cash flow calculation.
Determining the Discount Rate (WACC)
In a DCF model, future cash flows are discounted using the Weighted Average Cost of Capital (WACC). This rate reflects the required return expected by both debt and equity investors. It acts as the benchmark for converting future values into today’s terms.
WACC is calculated using the following formula:
WACC = (E / (D + E)) × Re + (D / (D + E)) × Rd × (1 – Tc)
Where:
- E = Market value of equity
- D = Market value of debt
- Re = Cost of equity
- Rd = Cost of debt
- Tc = Corporate tax rate
The cost of equity is usually estimated using the Capital Asset Pricing Model (CAPM):
Re = Risk-Free Rate + Beta × Market Risk Premium
In most banking models, the WACC is calculated in a separate input sheet or in the assumptions section, then linked directly into the DCF tab. It should remain editable, so the user can adjust it as needed or run sensitivities.
WACC must be consistent with the free cash flow being discounted. If the model uses unlevered free cash flows, the appropriate discount rate is the after-tax WACC. If the model uses levered free cash flows, the cost of equity is used instead.
A good model also tests the impact of small changes in WACC on valuation, since even small movements in the rate can significantly affect enterprise value.
Discounting Cash Flows and Calculating Present Value
Once the free cash flows and terminal value are projected, the next step is to calculate their present value using the discount rate. This is the core of the DCF method — converting future cash into today’s value, based on the time value of money.
Each year’s free cash flow is discounted using the following formula:
PV of Year n = FCFn / (1 + WACC)n
This is repeated for every forecast year. The terminal value, calculated in the final year, is also discounted back to present value using the same formula. Once all discounted values are calculated, they are summed together:
Enterprise Value = ∑ (PV of FCFs) + PV of Terminal Value
In Excel, this is usually structured in a table format, with columns showing:
- Each year of the forecast
- Free cash flow
- Discount factor
- Present value
These steps should be clearly shown in the model. Avoid embedding complex formulas into a single cell — each part of the calculation should be visible and easy to audit.
A well-structured DCF allows users to see exactly how value is built up from each year’s cash flows and terminal value, and how sensitive that value is to changes in the inputs.
Deriving Equity Value from Enterprise Value
The DCF model calculates the value of the business as a whole — the enterprise value. To reach the equity value, the model must adjust for non-operating items. This step is known as the equity value bridge.
The basic formula is:
Equity Value = Enterprise Value – Net Debt + Cash Adjustments
Where:
- Net Debt = Total debt – excess cash
- Additional adjustments may include preferred stock, minority interest, or non-operating assets
Each component of the bridge should be clearly shown in a separate section of the DCF model. These figures are usually taken from the balance sheet in the final forecast year or from the latest available financials, depending on the context.
Once equity value is calculated, dividing it by the fully diluted share count gives the implied share price. This is often used as a reference in fairness opinions, IPO valuation discussions, or target price setting.
This final step ensures that the DCF output is aligned with what shareholders actually care about: the value of their equity stake in the business.
Sensitivity Analysis
The DCF model is highly sensitive to small changes in assumptions — especially the discount rate, terminal growth rate, and cash flow forecasts. That’s why sensitivity analysis is a standard feature in every professional DCF file.
In practice, models include two-way sensitivity tables showing how the implied enterprise value or equity value changes across a range of inputs. Common variables include:
- WACC vs. Terminal Growth Rate
- WACC vs. Exit Multiple (if using the multiple-based terminal value)
- Revenue Growth vs. EBITDA Margin
- Capex vs. Working Capital
These tables are usually built using Excel’s DATA TABLE function, placed at the bottom of the DCF sheet or in a dedicated “Outputs” tab. Each cell in the table pulls from the DCF valuation logic, ensuring that results update automatically if assumptions change.
Sensitivity tables help assess how robust the valuation is and how conservative or aggressive the base case appears. They’re also useful when preparing client materials, especially in M&A or IPO discussions where valuation ranges are scrutinized closely.
A clean, functioning sensitivity analysis adds both transparency and credibility to the model.
Closing Thought
Building a DCF model is about structuring assumptions, calculations, and outputs in a way that is logical, transparent, and ready for real decisions. In investment banking, a well-built DCF must be both technically sound and easy to explain. When done right, it becomes one of the most powerful tools in financial analysis.