The Discounted Cash Flow, or DCF, is one of the most respected—and misunderstood—valuation methods in investment banking. Everyone uses it. Few people trust it. And yet, when built correctly, it’s one of the most powerful tools you can use to understand what a business is worth based on its ability to generate cash in the future.
What makes DCF special is that it looks beyond current market prices. It asks: What is this company fundamentally worth if we think about the cash it will generate going forward? It then takes those future cash flows and brings them back to today’s value using a concept called discounting—which is really just finance’s way of saying, “money in the future is worth less than money today.”
In this article, we’ll break the DCF down into its core components. You’ll learn how to project free cash flows, how to calculate the discount rate (WACC), how to estimate terminal value, and how to tie it all together into a defendable valuation. Most importantly, we’ll explain it in a way that makes sense—even if you’re not a mathematician.
What Is the Logic Behind DCF?
The DCF method is based on a simple idea:
A business is worth the money it will generate in the future—adjusted for the risk and time value of money.
Let’s say you’re evaluating a business that is expected to generate $10 million in free cash flow next year. Would you pay $10 million for it today? Probably not. You’d expect a return on your investment. And you’d want to discount that $10 million to reflect the fact that you’re taking on risk and giving up your money now in exchange for cash later.
This is what DCF does. It projects all the future free cash flows the business is expected to generate, then discounts them back to today using a rate that reflects both the cost of capital and the riskiness of those cash flows. The sum of all those discounted cash flows gives you the enterprise value of the business.
DCF is considered a pure valuation method because it is not based on what the market is doing. It’s based on what the company is expected to do. But that also means it’s highly sensitive to assumptions—about growth, margins, investments, and risk. A small change in those inputs can lead to big swings in valuation, which is why a good DCF is always backed by logic, data, and sensitivity analysis.
How to Forecast Free Cash Flows in a DCF Model
Everything in a DCF starts with free cash flow—because that’s what investors ultimately care about. Not revenue. Not profit on paper. But real cash that the business can use to reinvest, pay debt, or return to shareholders.
So what exactly is free cash flow?
In simple terms, it’s the cash left over after a company pays for everything it needs to keep the business running. That means after covering operating costs, taxes, investments in machinery or technology (called capital expenditures), and any money tied up in inventory or unpaid customer bills (called working capital).
A common formula used in DCF models looks like this:
Free Cash Flow (FCF) = EBIT × (1 - Tax Rate)
+ Depreciation & Amortization
- Capital Expenditures
- Change in Working Capital
Let’s break that down with an example.
Imagine your coffee chain generates $20 million in operating profit (EBIT). It pays a 30% tax rate, which means $6 million goes to taxes, leaving $14 million after tax. Then you add back $2 million of non-cash expenses like depreciation. But the company needs to invest $5 million in new store equipment (capex) and tie up $1 million in additional working capital as it grows.
So the free cash flow would be:
Example:
$20 million × (1 - 30%) = $14 million
+ $2 million Depreciation
- $5 million CapEx
- $1 million Change in Working Capital
= $10 million Free Cash Flow
You repeat this process for each year of your forecast, usually 5 to 10 years into the future, based on the company’s expected growth and investment plans. The more realistic and data-driven your forecast, the more credible your DCF becomes.
But forecasting doesn’t stop there. After those detailed years, you still need to capture the value beyond the forecast period—that’s where terminal value comes in.
How to Estimate Terminal Value in a DCF
No company stops operating after five or ten years. Yet, your forecast will usually only cover that initial period. This creates a challenge—how do you capture all the value that comes after your forecast ends?
That’s where terminal value comes in. Terminal value represents the long-term value of the business beyond the forecast period. And in most DCF models, it makes up the largest portion of the total valuation—sometimes more than 50%, especially for companies expected to grow for many years.
There are two main ways to calculate terminal value:
1. Gordon Growth Method (Perpetuity Growth)
This method assumes the company keeps growing at a stable, low rate forever, usually in line with long-term inflation or GDP growth (for example, 2% to 3%).
The formula looks like this:
Terminal Value = Final Year Free Cash Flow × (1 + g) / (r - g)
Where:
- g = long-term growth rate
- r = discount rate (WACC)
For example, if the final year free cash flow is $10 million, the long-term growth rate is 2%, and the discount rate is 8%, the terminal value would be:
Terminal Value = $10 million × (1 + 2%) / (8% - 2%) = $10.2 million / 6% = $170 million
2. Exit Multiple Method
This method applies a market-based multiple (like EV/EBITDA) to the company’s final year financials, based on what similar businesses are valued at today.
For example, if similar companies are valued at 10× EBITDA, and your company’s final year EBITDA is $20 million, the terminal value would be:
Terminal Value = $20 million × 10 = $200 million
Both methods are valid, but they tell slightly different stories. The Gordon Growth method focuses on long-term fundamentals, while the Exit Multiple method ties the value to current market conditions. That’s why experienced bankers often run both and compare the results to check if they make sense.
Once you have the terminal value, you discount it back to today’s value, just like you do with the yearly cash flows. This gives you the total enterprise value of the company.
How to Calculate the Discount Rate (WACC)
So far, you’ve forecasted free cash flows and estimated terminal value. But to bring all those future dollars back to today’s value, you need to apply a discount rate. In a DCF model, that discount rate is usually the Weighted Average Cost of Capital, or WACC.
WACC represents the blended cost of both equity (shares) and debt (loans or bonds) used to finance the business.
It answers the question:
What return do investors and lenders expect in exchange for the risk they are taking by putting money into this company?
The WACC Formula
WACC = (E / (E + D)) × Re + (D / (E + D)) × Rd × (1 - Tc)
Where:
- E = Market value of equity (shares)
- D = Market value of debt (loans or bonds)
- Re = Cost of equity (usually calculated using CAPM)
- Rd = Cost of debt (interest rate on the company’s debt)
- Tc = Corporate tax rate (because interest on debt is tax-deductible)
Example
Imagine your company has $80 million in equity and $20 million in debt.
The cost of equity (Re) is 10%, the cost of debt (Rd) is 5%, and the tax rate (Tc) is 30%.
Plugging these into the formula:
WACC = (80 / 100) × 10% + (20 / 100) × 5% × (1 - 30%)
= 8% + 0.7%
= 8.7%
Your discount rate is 8.7%, meaning investors expect at least that return for the risk they are taking.
Where Do You Get These Inputs?
- Cost of Equity (Re) is typically estimated using the Capital Asset Pricing Model (CAPM), which considers the risk-free rate, the market risk premium, and the company’s beta (a measure of risk relative to the market).
- Cost of Debt (Rd) is based on the company’s actual or estimated borrowing cost—the interest rate it pays on loans or bonds.
- Equity and Debt values are usually based on market data, not just book values on the balance sheet.
You’ll often pull these inputs from data providers like Bloomberg, FactSet, or FinancialModelingPrep, or estimate them based on comparable companies if direct data isn’t available.
Once you have the WACC, you use it to discount all future cash flows and the terminal value back to today, completing the core calculation of the DCF.
Calculating the Enterprise Value
Once you have your forecasted free cash flows, your terminal value, and your discount rate (WACC), you’re ready to pull it all together.
Here’s how it works.
You discount each year’s free cash flow and the terminal value back to today’s value using the WACC. This gives you what’s called the Present Value (PV) of each cash flow.
For example, if your WACC is 8%, and you’re discounting a $10 million cash flow expected in year 1, the formula looks like this:
Present Value = $10 million / (1 + 8%)^1 = $9.26 million
You do this for every year in your forecast, plus the terminal value at the end.
Once you add up all those discounted values, you get the Enterprise Value (EV) of the business. This represents the total value of the company’s operations, before considering debt or cash.
From Enterprise Value to Equity Value
Most clients care about equity value—the value of the shares after paying off debt and adding back any excess cash.
To get there, you adjust the enterprise value:
Equity Value = Enterprise Value - Net Debt
Where Net Debt is:
Net Debt = Total Debt - Cash
So if your enterprise value is $200 million, the company has $50 million in debt, and $10 million in cash, the equity value would be:
Equity Value = $200 million - ($50 million - $10 million) = $160 million
This equity value is what you ultimately compare to the market capitalization if it’s a public company, or what you use to set the price per share in a private transaction or IPO.
Closing Thoughts
The DCF might seem complex at first, but at its core, it’s just about answering one simple question: How much cash will this business generate in the future, and what is that worth today? Everything else—projections, discounting, terminal value, WACC—is just the machinery you use to get to that answer.
What makes DCF powerful is that it looks beyond market noise and focuses on the fundamentals. What makes it risky is that it depends entirely on the assumptions you build into the model. That’s why no DCF is complete without sensitivity checks, cross-method comparisons, and clear communication of the risks.
In the next article, we’ll shift gears to explore Comparable Company Analysis, where the value comes not from future projections, but from how the market is pricing similar businesses today.