DCF Valuation, Step by Step

Multiples told you what a company is worth relative to its peers. A discounted cash flow (DCF) asks the deeper question: what is this business worth in absolute terms, from first principles? The answer rests on one idea you already own from the time-value course — a dollar tomorrow is worth less than a dollar today — applied to every dollar of cash a company will ever generate. Done well, a DCF forces you to make your assumptions explicit and shows you exactly what you’re betting on. Done naively, it produces a falsely precise number that crumbles the moment you nudge an input. This lesson builds one end to end, then shows you how fragile it is.

The core principle — a company is its discounted future cash

Analogy. Imagine a magic apple tree that will produce a known harvest of apples every year forever. What’s the tree worth today? Not the wood it’s made of — its worth is the value of all those future harvests, with each year’s harvest worth a little less to you the longer you must wait for it. A company is that tree; its free cash flows are the harvests; the discount rate is your impatience.

Definition. The value of a business is the sum of its future free cash flows, each discounted to present value:

$\text{Value} = \sum_{t=1}^{n} \frac{\text{FCF}_t}{(1 + r)^t} + \frac{\text{Terminal Value}}{(1 + r)^n}$

where $\text{FCF}_t$ is free cash flow in year $t$, $r$ is the discount rate, and the terminal value captures all cash flows beyond the explicit forecast. Three ingredients, each its own section: the cash flows, the discount rate, and the terminal value.

Step 1 — project free cash flow

Definition. Recall from the cash-flow lesson: free cash flow is the cash a business throws off after funding its operations and investments — the cash genuinely available to investors:

$\text{FCF} = \text{Operating Cash Flow} - \text{Capital Expenditure}$

(A fuller version, unlevered FCF, starts from after-tax operating profit and is the standard input to a whole-company DCF — but the intuition is identical: cash left over for those who funded the business.) You project it forward, typically 5–10 years, off explicit assumptions about revenue growth, margins, and reinvestment.

Worked example. Suppose a company generates $100M of free cash flow this year and you project it grows 8% a year for five years:

These are the harvests. Notice the whole projection hangs on the growth assumption — change 8% to 4% and every number shrinks. Your forecast is only as good as the business understanding behind it, which is why the three-statement work in this course comes first: you can’t project free cash flow you can’t read.

Misconception. “A longer, more detailed forecast makes a DCF more accurate.” Usually the opposite. Projecting 20 years out multiplies your guesses, and the far-future numbers are mostly fiction. Most of a DCF’s real information lives in the next 3–5 years plus the terminal value; piling on spurious yearly detail adds false precision, not insight.

Step 2 — choose the discount rate (WACC)

Analogy. The discount rate is the return investors demand for putting their money at risk in this business instead of a safe alternative. A rock-steady utility might be discounted at 7% (low risk, low demanded return); a volatile startup at 15% (high risk, investors want more to compensate). The riskier the cash flows, the harder you discount them — and the less they’re worth today.

Definition. For a whole-company DCF, the standard discount rate is the weighted average cost of capital (WACC) — the blended return demanded by all the company’s funders, debt and equity, weighted by how much of each it uses:

$\text{WACC} = \frac{E}{V} \cdot r_e + \frac{D}{V} \cdot r_d \cdot (1 - \text{tax})$

where $r_e$ is the cost of equity (often from CAPM, which you met in portfolio theory), $r_d$ is the cost of debt, and $E$, $D$, $V$ are the market values of equity, debt and the total. Debt’s cost is multiplied by $(1 - \text{tax})$ because interest is tax-deductible — the tax shield you met in the linking lesson.

Worked example. A company is 70% equity (cost 10%) and 30% debt (cost 5%), with a 20% tax rate:

$\text{WACC} = 0.70 \times 10\% + 0.30 \times 5\% \times (1 - 0.20) = 7.0\% + 1.2\% = 8.2\%$

So future cash flows get discounted at 8.2%. A higher WACC — from more risk or pricier debt — makes the same cash flows worth less today.

Step 3 — the terminal value (which dominates everything)

The problem. You can’t forecast cash flows forever, but a company doesn’t stop generating them after year 5. The terminal value bundles all cash flows beyond the explicit forecast into a single number at the end of the projection. And here’s the unsettling truth: in most DCFs, the terminal value is the majority of the total — often 60–80%. The number you’re most unsure about matters the most.

Definition — the perpetuity-growth (Gordon) method. Assume that after the forecast, free cash flow grows forever at a modest constant rate $g$ (no faster than the economy, or the company would eventually swallow the world). The value of that perpetual stream, as of the final forecast year, is:

$\text{Terminal Value} = \frac{\text{FCF}_{n} \times (1 + g)}{r - g}$

This terminal value sits at year $n$ and must itself be discounted back to today like any other future sum.

Worked example. Final-year FCF $146.9M, perpetual growth $g = 2.5\%$, WACC $r = 8.2\%$:

$\text{Terminal Value} = \frac{146.9 \times 1.025}{0.082 - 0.025} = \frac{150.6}{0.057} \approx \$2{,}642M$

That single number — discounted back five years — typically dwarfs the sum of the five explicit cash flows. Which is exactly why the assumptions buried inside it ($r$ and $g$) deserve the most scrutiny of anything in the model.

Misconception. “The terminal growth rate is a minor detail.” It’s the opposite — it’s one of the two most consequential inputs in the entire DCF. Because terminal value uses $r - g$ in the denominator, a tiny change in $g$ swings the answer enormously: nudge $g$ from 2% to 3% (with $r = 8\%$) and the denominator shrinks from 6% to 5%, inflating terminal value by 20%. And $g$ can never exceed $r$, or the formula explodes into nonsense (a “company” growing faster than its discount rate forever is worth infinity).

Step 4 — sum it all up

Worked example — putting it together. Discount each year’s free cash flow and the terminal value at 8.2%, then add:

The five explicit years contribute about $497M of present value; the terminal value contributes $1,781M — roughly 78% of the total. To get from enterprise value to a per-share price, subtract net debt (to reach equity value) and divide by shares outstanding — the reverse of the EV bridge you built last lesson.

Step 5 — sensitivity analysis (the honesty check)

A single DCF number — “this company is worth $2,278M” — radiates false confidence. The discipline that separates a real analyst from a spreadsheet jockey is the sensitivity table: re-run the DCF across a range of discount rates and terminal growth rates and watch the answer swing. The output isn’t a point; it’s a range, and the width of that range is the honest measure of how much you actually know.

What the grid teaches. Move the discount rate one point or the growth rate one point and the implied value can shift by a third or more — because both feed the $r - g$ denominator of the terminal value, where small changes are amplified. This is not a flaw to be hidden; it’s the truth about valuation. A DCF’s job isn’t to spit out a magic number but to tell you what you’d have to believe for today’s price to make sense. If a stock only looks cheap under a heroic growth rate and a generously low discount rate, the grid exposes that instantly.

When to trust a DCF — and when not to

A DCF is most reliable for stable, predictable, cash-generative businesses — mature consumer staples, utilities, established software — where the next decade of cash flows can be forecast with some confidence. It’s least reliable for early-stage, cyclical, or rapidly changing businesses, where the cash flows are guesswork and the terminal value is a leap of faith.

The deepest value of a DCF often isn’t the number at all — it’s the discipline. Building one forces you to state, in numbers, exactly what you believe about a company’s growth, margins, and risk. Even when the final figure is too uncertain to trust, the act of deriving it tells you what assumptions the market price is embedding — and whether you find those assumptions plausible or absurd.

A mixed recap pulling from the whole lesson:

Key Takeaways