A discounted cash flow model (DCF) estimates the value of an investment based on its expected future cash flows, adjusted (discounted) to reflect the time value of money. The fundamental principle: a dollar of cash flow today is worth more than a dollar received in the future. The model calculates this by using the formula
, where $CF$ is the cash flow and $r$ is the discount rate.
DCF analysis is used to value businesses, projects, stocks, and any other investment that generates future cash.
How the DCF Model Works
At its core, a DCF model has three inputs:
| Input | What It Is | Where It Comes From |
|---|---|---|
| Free Cash Flows (FCF) | Cash generated by the investment each year | Financial projections / historical growth rates |
| Discount Rate (WACC) | Required rate of return reflecting risk | Cost of capital calculation |
| Terminal Value | Value beyond the explicit forecast period | Perpetuity growth formula or exit multiple |
Basic DCF Formula:
> DCF Value = FCF₁/(1+r)¹ + FCF₂/(1+r)² + … + (FCFₙ + TV)/(1+r)ⁿ
Building a Simple DCF: Step by Step
Step 1: Project Free Cash Flows
Estimate cash flows for 5-10 years based on revenue growth, margins, and capital expenditure assumptions.
Step 2: Choose a Discount Rate
Most corporate DCF models use the Weighted Average Cost of Capital (WACC) – typically 8-12% for most businesses.
Step 3: Calculate Terminal Value
Beyond your forecast period, assume a stable growth rate (usually 2-3%, in line with long-term GDP growth):
> Terminal Value = FCFₙ × (1 + g) / (WACC − g)
Step 4: Discount Everything Back
Apply the discount rate to each year’s cash flow and the terminal value.
Step 5: Sum It All Up
The sum of discounted cash flows = Enterprise Value of the business or investment.
Example: Simplified DCF
Assume a company generates $1M in free cash flow, growing 10% annually for 5 years, with a 10% WACC and 3% terminal growth rate:
| Year | FCF | Discount Factor (10%) | PV of FCF |
|---|---|---|---|
| 1 | $1,100,000 | 0.909 | $999,900 |
| 2 | $1,210,000 | 0.826 | $999,460 |
| 3 | $1,331,000 | 0.751 | $999,581 |
| 4 | $1,464,100 | 0.683 | $999,880 |
| 5 | $1,610,510 | 0.621 | $1,000,127 |
| Terminal Value | $23,293,143 | 0.621 | $14,455,141 |
| Total DCF Value | ~$19.45M |
Strengths and Weaknesses of DCF
| Strength | Weakness |
|---|---|
| Theoretically sound (intrinsic value) | Very sensitive to discount rate assumptions |
| Considers all future cash flows | Terminal value often drives 60-80% of value |
| Can be used for any cash-generating asset | Garbage in, garbage out – projections must be realistic |
| Flexible and customizable | Requires significant financial modeling skill |
The biggest criticism of DCF models is that small changes in the discount rate or terminal growth rate can swing the final valuation by 30-50%. This is why analysts always present a range of scenarios (bull, base, bear case) rather than a single number.
The Bottom Line
The discounted cash flow model is the gold standard of investment valuation. It forces you to think rigorously about future performance and the time value of money. Used alongside comparable company multiples and transaction analysis, it provides the most complete picture of what an asset is truly worth.
