Discounted cash flow (DCF) basics, step by step

A discounted cash flow model values a business as the total of the cash it is expected to produce in the future, with each amount reduced to reflect that money received later is worth less than money received today. It is the foundation of most serious valuation work, because it forces you to state assumptions about growth, profitability and risk. Its main weakness is that the answer is only as good as those assumptions.

The core idea

A dollar next year is worth less than a dollar today, because you could invest today's dollar and because the future is uncertain. Discounting converts future cash into today's terms using a discount rate. Add up all the discounted cash flows and you have the value of the business today.

Enterprise value = FCF1/(1+r) + FCF2/(1+r)^2 + ... + FCFN/(1+r)^N
                 + Terminal value / (1+r)^N

Equity value     = enterprise value - debt + cash
Value per share  = equity value / diluted shares

Here FCF is free cash flow to the firm, r is the discount rate, and N is the last explicit forecast year.

The five steps

1. Forecast free cash flow for a period, commonly five to ten years. Start from revenue growth and margins, then subtract taxes, reinvestment and capital spending. See free cash flow explained.
2. Choose the discount rate. For cash flows to the whole firm, this is usually the weighted average cost of capital; see WACC and discount rates and the CAPM.
3. Estimate the terminal value, which captures everything after the forecast period. See terminal value.
4. Discount each cash flow and the terminal value to the present and add them up. That gives enterprise value.
5. Bridge to shareholders. Subtract debt, add cash, and divide by diluted shares.

Example (illustrative numbers)

A company is expected to generate free cash flow of $100, $110, $120, $130 and $140 million over the next five years. The discount rate is 10% and long-run growth afterward is 3%. It has $200 million of net debt and 100 million shares.

Terminal value at the end of year 5, using the growing-perpetuity formula:

TV = 140 x (1 + 0.03) / (0.10 - 0.03) = 2,060
PV of TV = 2,060 / 1.1^5 = about 1,279

Putting it together:

Enterprise value = 447.7 + 1,279.1 = about 1,727
Equity value     = 1,727 - 200 net debt = about 1,527
Per share        = 1,527 / 100 = about $15.27

What the example shows

Notice that the terminal value contributes roughly 74% of the total. That is typical: for most companies, the majority of a DCF value sits beyond the explicit forecast, which is why the long-run assumptions deserve the most scrutiny.

The result is also sensitive to the discount rate. Raising it by one percentage point, to 11%, lowers the value per share to about $13.06. Cutting it to 9% raises it to about $18.22. A small change in inputs produces a large change in output.

How to read a DCF

Rules of thumb:

• Treat the output as a range, not a point. Run low, base and high scenarios.
• Ask what the model needs to be true. Which growth rates and margins are baked in, and are they consistent with the company's history and industry?
• Use the DCF to test the price. A reverse DCF works backward from the market price to the expectations it implies.
• Triangulate. Compare with multiples-based approaches rather than relying on one method.

Common mistakes

• Mismatched rates and cash flows. Cash flow to the whole firm should be discounted at the WACC; cash flow to equity holders at the cost of equity.
• Hockey-stick forecasts. Assuming rapid improvement that arrives conveniently late in the forecast.
• Terminal growth too high. A company cannot outgrow the economy forever.
• Ignoring stock-based pay. If it is not treated as a cost and the share count ignores future dilution, value per share is overstated.
• Double counting cash, or forgetting debt-like items such as leases or pensions.
• False precision. A value of "$15.27" implies accuracy the inputs cannot support.

Where to see it on StocksXray

A 10-year DCF scaled to the market's average is one of the three models blended into StocksXray's fair value, alongside peer multiples and a fundamentals-adjusted multiple. Typical model error is around 40%, which is why fair value is shown as a range. The methodology page has the details.

Key takeaways

• A DCF discounts expected future free cash flows, plus a terminal value, to a present value.
• The five steps are forecast, choose the rate, estimate terminal value, discount, and bridge to per-share value.
• Terminal value often supplies most of the result, so long-run assumptions dominate.
• Use a DCF to structure thinking and test expectations, not to produce a single exact number.