The idea behind discounted cash flow
A business is worth the cash it will produce for its investors, discounted for time and risk. The discounted cash flow (DCF) method forecasts free cash flow, discounts it at the cost of capital and adds a terminal value for the years beyond the forecast. The result is the enterprise value, the value of the operations to all capital providers.
| Step | What you do | Common trap |
|---|---|---|
| 1. Forecast free cash flow | Project operating cash after tax and reinvestment for 5 to 10 years | Growth rates with no link to market or capacity |
| 2. Choose the discount rate | Use WACC for the business (see our guide to cost of capital) | Rate inconsistent with the cash flows |
| 3. Estimate terminal value | Value all cash flows after the forecast period | Terminal value assumptions dominate the answer |
| 4. Sum to enterprise value | Add the present values | Mixing mid-year and year-end timing |
| 5. Bridge to equity | Subtract net debt and other claims | Forgetting leases, pensions or minorities |
| 6. Test and cross-check | Run sensitivities and compare with multiples | Presenting one number as precise |
Step 1: free cash flow
Free cash flow to the firm (FCFF) is the cash available to all investors after the business has paid taxes and funded its reinvestment:
FCFF = EBIT x (1 - T) + depreciation - capital expenditure - increase in working capital
Building a cash flow line (hypothetical, $ millions)
EBIT = 160; tax rate 25 percent; depreciation = 40; capital expenditure = 50; increase in working capital = 10.
EBIT x (1 - T) = 160 x 0.75 = 120. FCFF = 120 + 40 - 50 - 10 = 100.
Anchor growth in reality: market growth, price and volume assumptions, and capacity limits. Faster growth needs more reinvestment, so do not raise revenue without raising capital spending and working capital.
Steps 2 to 4: discount and add terminal value
Assume FCFF of 100, 110, 121, 133 and 146 over five years, a WACC of 9 percent and a long-run growth rate of 3 percent.
| Year | FCFF | Discount factor at 9% | Present value |
|---|---|---|---|
| 1 | 100 | 1 / 1.09 = 0.9174 | 91.74 |
| 2 | 110 | 1 / 1.1881 = 0.8417 | 92.59 |
| 3 | 121 | 1 / 1.2950 = 0.7722 | 93.43 |
| 4 | 133 | 1 / 1.4116 = 0.7084 | 94.22 |
| 5 | 146 | 1 / 1.5386 = 0.6499 | 94.89 |
| Total of years 1 to 5 | 466.87 |
The terminal value at the end of year 5 uses the growing perpetuity formula: TV = FCFF in year 6 / (WACC - g) = 146 x 1.03 / (0.09 - 0.03) = 150.38 / 0.06 = 2,506.3. Its present value is 2,506.3 / 1.5386 = 1,628.9.
Enterprise value = 466.9 + 1,628.9 = about 2,095.8 ($ millions).
Notice that 1,628.9 / 2,095.8 = 78 percent of the value sits in the terminal value. That is typical and is the main weakness of the method: small changes in growth or discount rate change the answer a lot.
Step 5: from enterprise value to a share price
Equity bridge (hypothetical)
| Item | $ millions |
|---|---|
| Enterprise value | 2,095.8 |
| Less: net debt (debt minus cash) | (400.0) |
| Equity value | 1,695.8 |
| Shares outstanding (millions) | 100 |
| Value per share | $16.96 |
Include every claim that ranks ahead of ordinary shareholders: debt, finance leases, preferred shares, underfunded pensions and minority interests. Then compare with the market price. If the market price is $14, say why you believe the market is undervaluing the firm, or why your assumptions might be too optimistic.
Step 6: sensitivity and scenarios
A single valuation looks more certain than it is. Show how the answer changes when the key assumptions change.
| Scenario | WACC | Terminal growth | Enterprise value ($m) |
|---|---|---|---|
| Base case | 9% | 3% | 2,096 |
| Lower growth | 9% | 2% | 1,850 |
| Higher discount rate | 10% | 3% | 1,788 |
The base case is 17 percent above the higher-rate case (2,096 vs 1,788) from a single point in the discount rate. Present the valuation as a range and explain which assumptions matter most. Build the model in a spreadsheet with inputs in one place so you can update scenarios quickly; see our guide to decision analysis for scenario weighting.
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Get an instant quoteCross-check with multiples
Comparable company analysis values the firm using the ratios at which similar firms trade, such as enterprise value to EBITDA (EV/EBITDA), price to earnings (P/E) or enterprise value to sales. If the firm's EBITDA is $200 million and peers trade at 10 times EBITDA, the multiple implies an enterprise value of $2,000 million, close to the DCF result of $2,096 million. A close match raises confidence. A large gap needs an explanation: higher growth, weaker margins, or different risk.
| Method | Strength | Weakness |
|---|---|---|
| DCF | Based on the firm's own cash flows and assumptions | Sensitive to terminal value and discount rate |
| Trading multiples | Reflects current market pricing | Hard to find truly comparable firms; reflects market mood |
| Precedent transactions | Shows prices paid for control | Includes control premiums and old deal conditions |
Timing: year-end versus mid-year cash flows
The model above treats every cash flow as arriving on the last day of the year. If cash arrives evenly through the year, mid-year discounting is more realistic: each cash flow is discounted for half a year less.
That is equivalent to multiplying each present value by (1 + discount rate) raised to the power 0.5. At 9 percent, the factor is 1.09 to the power 0.5, which is about 1.0440. The present value of the five forecast cash flows becomes 466.87 x 1.0440 = about 487.4 instead of 466.9, a lift of 4.4 percent.
The effect on the full valuation depends on how you treat the terminal value, so say which convention you use and keep it consistent. Many courses use year-end discounting for simplicity; use the one your instructor specifies.
Reverse DCF: what is the market assuming?
Instead of asking what the firm is worth, ask what the market price implies. This is a good way to discuss whether a stock looks cheap or expensive without pretending to precision.
Implied terminal growth (hypothetical)
The market enterprise value is 1,900, compared with 2,096 from the model. With the forecast cash flows and a 9 percent discount rate unchanged, the present value of the forecast period is 466.9, so the terminal value must account for 1,900 - 466.9 = 1,433.1 in present terms. At the end of year 5 that is 1,433.1 x 1.5386 = 2,205.
Solve 146 x (1 + g) / (0.09 - g) = 2,205: 146 + 146g = 198.45 - 2,205g, so 2,351g = 52.45 and g = 2.2 percent.
The market is pricing roughly 2.2 percent long-run growth, against your 3 percent. The question for your recommendation becomes whether 3 percent is justified by the firm's market and reinvestment, or whether the market is right to be more cautious. That is a more honest framing than saying the stock is worth exactly $16.96.
Writing the valuation memo
| Section | What to include |
|---|---|
| Conclusion | Value range per share, comparison with the market price, and the recommendation |
| Business and forecast drivers | Growth, margins, reinvestment, with the evidence for each |
| Discount rate | The inputs and why they are reasonable |
| Terminal value | Growth rate and the share of value it represents |
| Sensitivity | A table of value against WACC and growth |
| Cross-check | Multiples and what a gap would mean |
| Risks | The two assumptions most likely to be wrong |
- Put assumptions on one page So the reader can challenge them.
- Say how much value sits in the terminal value And whether you are comfortable with it.
- Avoid false precision A range of 15 to 18 dollars is more credible than 16.96.
Common mistakes and how to write it up
- Mixing nominal and real Use a nominal discount rate with nominal cash flows.
- Terminal growth above the economy Long-run growth rarely exceeds long-run economic growth, usually 2 to 4 percent.
- Double counting Do not subtract interest from FCFF and then discount at WACC; WACC already includes financing costs.
- Ignoring reinvestment Growth needs capital spending and working capital.
- No sensitivity A range is more honest than one number.
- Not explaining assumptions Give the reason for each key assumption.
In your write-up, present the recommendation first (buy, hold, sell or fair value), then the main assumptions, the model summary, the sensitivity range and the cross-check. If you would like help with a valuation assignment, you can order corporate finance assignment help.