DCF Guide: How to Build a Discounted Cash Flow Model
How a DCF Works
The premise is simple: a company is worth the sum of all future cash flows it will generate, adjusted for the time value of money. A dollar received five years from now is worth less than a dollar today because of inflation, risk, and opportunity cost. The DCF captures this by discounting each future cash flow back to its present value.
Step-by-Step DCF Process
| Step | Action | Key Inputs |
|---|---|---|
| 1. Project Revenue | Forecast 5–10 years of revenue growth | Historical growth, industry trends, management guidance |
| 2. Build to Free Cash Flow | Project margins, taxes, capex, working capital | Operating margins, capex intensity, tax rate |
| 3. Calculate WACC | Determine the discount rate | Cost of equity, cost of debt, capital structure |
| 4. Discount Cash Flows | Bring projected FCFs to present value | WACC as discount rate |
| 5. Calculate Terminal Value | Value beyond the projection period | Perpetuity growth rate or exit multiple |
| 6. Sum to Enterprise Value | PV of FCFs + PV of terminal value | — |
| 7. Bridge to Equity Value | Subtract debt, add cash | Net debt, minority interests |
| 8. Per-Share Value | Divide equity value by diluted shares | Diluted share count |
Projecting Free Cash Flow
Unlevered Free Cash Flow (UFCF) is the cash available to all capital providers (debt and equity) after operating expenses and reinvestment:
Project each component separately. Revenue drives everything — from there, apply margin assumptions to get EBIT, estimate tax rates, and project capital expenditures and working capital needs. The key is building a three-statement model that links the income statement, balance sheet, and cash flow statement together.
Terminal Value: Two Methods
| Feature | Gordon Growth Model | Exit Multiple Method |
|---|---|---|
| Formula | TV = FCFₙ × (1 + g) ÷ (WACC − g) | TV = EBITDAₙ × Exit Multiple |
| Key Assumption | Perpetual growth rate (g) | Trading multiple at exit year |
| Typical Values | g = 2–3% (GDP-like growth) | Based on comparable companies |
| Sensitivity | Very sensitive to g and WACC | Sensitive to multiple choice |
| Best Practice | Use as cross-check | Primary method on the Street |
Terminal value typically represents 60–80% of total enterprise value in a DCF. This means your assumptions about long-term growth and exit multiples matter enormously. Always run sensitivity analysis on these inputs.
From Enterprise Value to Share Price
| Step | Action |
|---|---|
| Enterprise Value | PV of projected FCFs + PV of terminal value |
| − Net Debt | Total debt − cash and equivalents |
| − Minority Interest | If applicable |
| − Preferred Equity | If applicable |
| + Equity Investments | Non-operating assets |
| = Equity Value | Value attributable to common shareholders |
| ÷ Diluted Shares Outstanding | Include options via treasury stock method |
| = Implied Share Price | Your DCF-derived target price |
Key Takeaways
- A DCF values a company by discounting projected free cash flows back to present value using WACC.
- Terminal value dominates the result (60–80% of total value), so test your assumptions rigorously.
- The enterprise-to-equity bridge (subtracting net debt) converts enterprise value to per-share equity value.
- Always present DCF results as a range using sensitivity analysis — a single point estimate is misleading.
- Cross-check your DCF with comparable company analysis and precedent transactions for a complete valuation picture.
Frequently Asked Questions
What discount rate should I use in a DCF?
Use WACC as the discount rate for unlevered free cash flows. A typical WACC for a large-cap US company is 8–12%. Riskier companies (small caps, emerging markets) warrant higher discount rates. The discount rate should reflect the riskiness of the cash flows being discounted.
How many years should I project in a DCF?
The standard is 5–10 years. Use 5 years for mature, stable businesses and up to 10 years for high-growth companies that haven’t reached steady-state margins. Beyond the projection period, terminal value captures the remaining value. Longer projections reduce terminal value dependence but introduce more assumption risk.
Why does terminal value dominate the DCF?
Terminal value captures all cash flows beyond your explicit projection period — essentially “forever.” Since companies are assumed to operate indefinitely, and near-term cash flows are smaller in magnitude, the terminal value naturally represents the bulk of total value. This is normal but underscores the importance of reasonable terminal assumptions.
What is the difference between levered and unlevered free cash flow?
Unlevered FCF (UFCF) is cash flow before debt payments — it represents cash available to all capital providers. Levered FCF (LFCF) is cash flow after interest and debt repayments — cash available only to equity holders. A standard DCF uses UFCF discounted at WACC to get enterprise value. An equity DCF uses LFCF discounted at cost of equity to get equity value directly.
Can I use a DCF for any company?
DCFs work best for companies with predictable, positive cash flows. They’re less reliable for pre-revenue startups, cyclical businesses with volatile cash flows, and financial institutions (use dividend discount models instead). If you can’t reasonably project cash flows, consider relative valuation methods like comparable company analysis.