Discounted cash flow (DCF) analysis estimates a company's intrinsic value by projecting its future cash flows and discounting them back to present value. It is the foundation of fundamental valuation and is used by analysts, private equity firms, and corporate finance teams worldwide.
The core principle
A dollar received today is worth more than a dollar received in the future because of inflation, risk, and the opportunity to invest that dollar elsewhere. DCF captures this by applying a discount rate to future cash flows, converting them into their present-day equivalent.
The DCF formula
Intrinsic Value = Sum of (FCFt / (1 + r)^t) + Terminal Value / (1 + r)^n
Where:
- FCFt = free cash flow in year t
- r = discount rate (typically the weighted average cost of capital, or WACC)
- t = year number
- n = final projection year
Step 1: Project free cash flows
Free cash flow (FCF) represents the cash a company generates after capital expenditures. Start with historical FCF and project 5 to 10 years forward based on revenue growth assumptions, margin trends, and capital expenditure needs.
| Year | Revenue | FCF margin | FCF |
|---|---|---|---|
| 1 | $100M | 15% | $15.0M |
| 2 | $110M | 16% | $17.6M |
| 3 | $121M | 16% | $19.4M |
| 4 | $131M | 17% | $22.3M |
| 5 | $141M | 17% | $24.0M |
Step 2: Determine the discount rate
The discount rate reflects the riskiness of the cash flows. For publicly traded companies, the weighted average cost of capital (WACC) is standard. WACC blends the cost of equity (often estimated using the Capital Asset Pricing Model) and the after-tax cost of debt, weighted by the company's capital structure.
Typical WACC ranges:
- Large-cap, stable companies: 7 to 9%
- Mid-cap companies: 9 to 12%
- Small-cap or high-risk companies: 12 to 18%
Step 3: Calculate terminal value
Since you cannot project cash flows indefinitely, a terminal value captures all cash flows beyond the projection period. The two common methods are:
Perpetuity growth method:
Terminal Value = FCFn x (1 + g) / (r - g)
Where g is the long-term growth rate (typically 2 to 3%, approximating GDP growth).
Exit multiple method:
Terminal Value = FCFn x EV/FCF multiple
Using the example above with a 10% WACC, 2.5% terminal growth rate, and Year 5 FCF of $24M:
Terminal Value = $24M x 1.025 / (0.10 - 0.025) = $328M
Step 4: Discount everything to present value
| Year | Cash flow | Discount factor (10%) | Present value |
|---|---|---|---|
| 1 | $15.0M | 0.909 | $13.6M |
| 2 | $17.6M | 0.826 | $14.5M |
| 3 | $19.4M | 0.751 | $14.6M |
| 4 | $22.3M | 0.683 | $15.2M |
| 5 | $24.0M | 0.621 | $14.9M |
| Terminal | $328.0M | 0.621 | $203.7M |
| Total | $276.5M |
The estimated enterprise value is $276.5M. Subtract net debt and divide by shares outstanding to get intrinsic value per share.
Sensitivity analysis
Small changes in assumptions produce large changes in output. Always test different scenarios:
| WACC / Growth rate | 2.0% | 2.5% | 3.0% |
|---|---|---|---|
| 9% | $322M | $352M | $389M |
| 10% | $261M | $277M | $296M |
| 11% | $217M | $227M | $239M |
The range from $217M to $389M illustrates why DCF produces a valuation range rather than a precise number.
Limitations
- Garbage in, garbage out. The output is only as good as the assumptions. Overly optimistic growth projections lead to inflated valuations.
- Terminal value dominance. Terminal value often represents 60 to 80% of total value, meaning a small change in the terminal growth rate has an outsized impact.
- Difficult for early-stage companies. Companies with negative or unpredictable cash flows are poorly suited to DCF analysis.
- Ignores market sentiment. DCF estimates intrinsic value, not market price. The two can diverge for extended periods.