What is a discounted cash flow (DCF)?

A dollar received in five years is worth less than a dollar today, because today’s dollar could be invested in the meantime and because the future one is uncertain. Discounting turns future cash into today’s money: present value = future cash ÷ (1 + r)^n, where r is the discount rate and n the number of years. At 10%, $100 received in five years is worth $100 ÷ 1.10^5 ≈ $62.09 today.

A DCF applies that to a whole business. The cash that matters is free cash flow: operating cash flow minus capital spending, the cash the owners could take out without harming the business. That is why DCF sits closest to the textbook definition of intrinsic value.

Present value (PV)
Future cash expressed in today’s money: cash ÷ (1 + discount rate)^years.
Discount rate
The yearly return you require for the risk of owning the business. Analysts often use the weighted average cost of capital (WACC); individual investors often use their own required return.
Terminal value
The value, at the end of the forecast, of all the cash flows after it, usually estimated with a perpetual growth formula or an exit multiple.
Enterprise value
The value of the whole business. Subtract net debt (debt minus cash) to get the value that belongs to shareholders.

Steps 1 and 2: forecast free cash flow and choose a discount rate

Step 1: forecast free cash flow for the next five to ten years. Start from the company’s history, then make explicit assumptions for revenue growth, margins and capital spending. Hypothetical: a company produced about $95 million of free cash flow last year, and you forecast $100 million, $110 million, $120 million, $130 million and $140 million for years 1 to 5. Strictly, a whole-company DCF uses free cash flow before interest payments, often called unlevered free cash flow, so the result is the value of the whole business.

Step 2: choose the discount rate, the yearly return you require for the risk. Analysts usually use the weighted average cost of capital (WACC); many individual investors use their own required return. A riskier business deserves a higher rate; the example uses 10%. Discount each year: $100 million ÷ 1.10 = $91 million, $110 million ÷ 1.10² = $91 million, then $90 million, $89 million and $87 million. As the drawing at the top shows, the further away the cash, the more it shrinks.

Higher interest rates push discount rates up and present values down, which is why growth stocks whose profits lie far ahead tend to react more to rates; the growth vs value stocks guide shows the arithmetic.

Step 3: calculate the terminal value

A company does not stop at year 5, so the DCF adds a terminal value for everything after it. The common formula assumes cash grows at a steady rate g forever: terminal value = free cash flow in year 6 ÷ (r − g). It is often called the Gordon growth formula.

Hypothetical, with 3% growth: year 6 cash = $140 million × 1.03 = $144.2 million. Terminal value = $144.2 million ÷ (0.10 − 0.03) = $2,060 million. That value sits at the end of year 5, so discount it like year 5’s cash: $2,060 million ÷ 1.10^5 ≈ $1,279 million today.

Two rules keep it sane. The growth rate must stay below the discount rate, or the formula breaks. And it should be modest, because no company can outgrow the economy forever; many analysts use a rate close to long-term inflation or economic growth. The alternative, an exit multiple such as 15 times final-year free cash flow, borrows today’s market pricing and has the same weakness: it is an assumption.

Step 4: from enterprise value to value per share

Add up the pieces, as in the drawing below. The five discounted cash flows sum to $448 million and the discounted terminal value is $1,279 million, so the enterprise value is $1,727 million. Subtract net debt, here $300 million of debt minus $100 million of cash = $200 million, to get an equity value of $1,527 million. With 50 million shares, the value is $1,527 million ÷ 50 million ≈ $30.54 per share.

Notice the split: about 74% of the value comes from the terminal value, the part furthest in the future and hardest to forecast. That is normal for a DCF, and it is the main reason to treat the result as an estimate. If the stock trades at $25, it is about 18% below this estimate; whether that is enough depends on the margin of safety you require and how much you trust the inputs.

Turn your phone sideways to read the drawing. Tap to close.

A hand-drawn waterfall chart in $ millions: five small green steps for the discounted forecast years, 91, 91, 90, 89 and 87, then a tall green terminal value step of +1,279, a gray enterprise value bar of 1,727, a red net debt step of −200 and a dark green equity value bar of 1,527, with an arrow to ÷ 50M = $30.54 per share; a note reads about three-quarters of the value is terminal value.

DCF sensitivity: how much do the assumptions matter?

Change only the discount rate and the terminal growth rate, keep the same five cash flows, and the value per share moves a lot. The table below shows the hypothetical company at discount rates from 8% to 12% and terminal growth from 2% to 4%.

The base case is $30.54. One point lower on the discount rate, 9%, gives $36.44, about 19% more; one point higher, 11%, gives $26.11, about 15% less. Across the whole table the value ranges from about $20.70 to $55.00, for one company with one set of forecasts. That is why many investors build a table like this and use a cautious cell, not the base case, as their conservative value.

Turn your phone sideways to read the drawing. Tap to close.

A hand-drawn sensitivity table of value per share: rows for discount rates of 8%, 9%, 10%, 11% and 12%, columns for terminal growth of 2%, 3% and 4%. Values run from $37.9, $44.7 and $55.0 in the top row to $20.7, $22.7 and $25.1 in the bottom row, tinted green for high values and red for low ones; the base case, $30.5 at 10% and 3%, is circled in yellow, and notes read same company, same cash flows and $20.7 → $55.0.

The limits of DCF: garbage in, garbage out

A DCF looks precise because it ends in a number with cents. The number is only as good as the forecasts behind it.

Use it to understand what the price assumes rather than to find the one right value: if today’s price only makes sense with 8% terminal growth, the market is asking a lot. Cross-check the result with simpler methods, such as earnings × a fair P/E ratio or peers’ valuation ratios. Its usual weak points:

  • Forecasts: cash flows five or ten years out are guesses, especially for young, cyclical or fast-changing businesses.
  • Terminal value: it often carries most of the value, and it rests on two of the least certain inputs, long-term growth and the discount rate.
  • Circular reasoning: tweaking assumptions until the DCF matches the price you hoped for proves nothing.
  • Wrong cash flow: free cash flow flattered by stock-based compensation, or by capital spending cuts the business can’t sustain, skews the result.
  • Declining businesses: a DCF built on last year’s cash flow overvalues a company whose cash flow is shrinking, the setup behind a value trap.