Guides
Discounted Cash Flow (DCF): How the Valuation Works
Discounted cash flow (DCF) is a valuation method that estimates what a business or asset is worth today by projecting its future free cash flows and discounting them back to present value using a required rate of return. The core idea: a dollar received in five years is worth less than a dollar today, so future cash gets shrunk to a present-day figure. In a standard enterprise DCF, you project unlevered free cash flow for 5 to 10 years, discount each year at the weighted average cost of capital (WACC), add a terminal value for everything beyond the forecast, and subtract net debt to reach equity value.
DCF is the workhorse of intrinsic valuation. Analysts use it for M&A, equity research, and internal capital decisions because it values a company on its own cash-generating ability rather than on what comparable companies happen to trade at. The tradeoff: the output is only as good as the inputs, and small changes in growth or discount rate can swing the answer materially.
The DCF formula
The present value of a business equals the sum of each year’s projected free cash flow divided by (1 + discount rate) raised to the power of the year number, plus the discounted terminal value. Written out:
PV = FCF₁ / (1+r)¹ + FCF₂ / (1+r)² + … + FCFₙ / (1+r)ⁿ + TV / (1+r)ⁿ
Here FCF is free cash flow in each period, r is the discount rate (WACC for an enterprise DCF), n is the number of forecast years, and TV is terminal value. The term 1 / (1+r)ᵗ is the discount factor for year t, and it always falls as t rises. That decay is the entire mechanism: cash further out counts for less.
The choice of cash flow and discount rate must match. Unlevered free cash flow (cash to all capital providers, before interest) pairs with WACC and produces enterprise value. Levered free cash flow (cash to equity holders only, after interest) pairs with the cost of equity and produces equity value directly. Mixing them, for example discounting unlevered cash flow at the cost of equity, produces a wrong answer.
Step 1: Project free cash flow
Free cash flow is the cash a company generates after funding operations and capital investment, and it is the input the DCF discounts. For an enterprise DCF you project unlevered free cash flow (also called free cash flow to the firm), because it represents cash available to both debt and equity holders before financing costs.
The standard build is:
Unlevered FCF = EBIT × (1 − tax rate) + Depreciation & Amortization − Capital Expenditures − Change in Net Working Capital
Each line has a reason. You start from EBIT and tax it to get net operating profit after tax, which strips out the effect of how the company is financed. You add back depreciation and amortization because they are non-cash charges. You subtract capital expenditures and any increase in net working capital because those consume real cash. The result is the cash the business throws off from operations, independent of its capital structure.
Projections usually run 5 to 10 years. The forecast should tie to a defensible operating model: revenue growth that fades toward a sustainable rate, margins that reflect the industry, and capex and working capital that scale with the business. For a refresher on where these figures originate, see how to read an income statement and the cash flow statement, explained.
Step 2: Discount at WACC
The weighted average cost of capital (WACC) is the blended required return on a company’s debt and equity, and it serves as the discount rate for an enterprise DCF. It answers the question: what return do all the company’s capital providers, taken together, demand to fund it?
The formula weights each source of capital by its share of the total:
WACC = (E/V × Re) + (D/V × Rd × (1 − Tc))
where E is equity value, D is debt, V is E + D, Re is the cost of equity, Rd is the cost of debt, and Tc is the marginal tax rate. The cost of debt is multiplied by (1 − Tc) because interest is tax-deductible in many jurisdictions, which lowers its effective cost. The cost of equity is often estimated with the capital asset pricing model (risk-free rate plus beta times the equity risk premium).
Once WACC is set, you compute a discount factor for each forecast year and multiply the year’s free cash flow by it. A higher WACC means future cash is discounted harder, lowering the valuation. This is why the discount rate is one of the two most sensitive inputs in the whole model.
Step 3: Estimate terminal value
Terminal value captures the worth of all cash flows beyond the explicit forecast period, and it usually accounts for 50% to 80% of the total enterprise value in a DCF. Because most of the answer often lives here, the terminal value assumptions deserve as much scrutiny as the forecast itself. Two methods dominate, and analysts frequently run both to cross-check.
Gordon growth (perpetuity growth) method
The Gordon growth method assumes free cash flow grows at a constant rate forever after the forecast period, then values that infinite stream as a growing perpetuity. The formula is:
Terminal Value = FCFₙ × (1 + g) / (WACC − g)
where FCFₙ is the final forecast year’s free cash flow and g is the perpetual growth rate. The growth rate g must be conservative, typically 2% to 4%, and it can never exceed the long-run growth rate of the broader economy, or the math implies the company eventually becomes larger than everything. A g above WACC breaks the formula entirely (the denominator goes negative). This method is grounded in theory but highly sensitive: a swing of 0.5% in g can move the valuation by double-digit percentages.
Exit multiple method
The exit multiple method assumes the business is sold at the end of the forecast period for a multiple of a financial metric, usually EBITDA. The formula is:
Terminal Value = Final-year metric × Exit multiple
For example, terminal-year EBITDA times an exit multiple drawn from comparable public companies or precedent M&A transactions. This method grounds the terminal value in observable market pricing, which many practitioners find more defensible than an assumed perpetual growth rate. The risk: it imports current market sentiment into a long-dated estimate, and multiples can be cyclical. Because EBITDA is the usual base, buyers scrutinize how it is defined; see the mechanics in EBITDA adjustments explained.
Whichever method you use, the terminal value lands in the final forecast year, so it must be discounted back to present value using the same year-n discount factor as the final year’s cash flow.
Worked mini-model
The table below values a business with $100 million of Year 1 unlevered free cash flow growing 8% annually, a WACC of 10%, and a terminal perpetual growth rate of 3%. All figures are in millions of dollars.
| Year | Free cash flow | Discount factor at 10% | Present value |
|---|---|---|---|
| 1 | 100.0 | 0.909 | 90.9 |
| 2 | 108.0 | 0.826 | 89.2 |
| 3 | 116.6 | 0.751 | 87.6 |
| 4 | 126.0 | 0.683 | 86.1 |
| 5 | 136.0 | 0.621 | 84.5 |
| Sum of discounted FCF (Years 1–5) | 438.3 |
Terminal value uses the Gordon growth method on Year 5 cash flow:
TV = 136.0 × (1.03) / (0.10 − 0.03) = 140.1 / 0.07 = 2,001.4
Discounted to today at the Year 5 factor: 2,001.4 × 0.621 = 1,242.9.
| Component | Value ($M) |
|---|---|
| PV of Years 1–5 free cash flow | 438.3 |
| PV of terminal value | 1,242.9 |
| Enterprise value | 1,681.2 |
| Less: net debt | (200.0) |
| Equity value | 1,481.2 |
Terminal value here is 74% of enterprise value, inside the typical 50% to 80% range and a reminder of how much weight the perpetuity assumption carries. If the business had 100 million shares outstanding, equity value per share would be about $14.81.
Enterprise value to equity value bridge
An enterprise DCF using unlevered free cash flow produces enterprise value, the value of the whole business to all capital providers. To reach the value belonging to shareholders, you adjust for the capital structure:
Equity value = Enterprise value − Total debt + Cash − Preferred stock − Minority interest
The largest adjustment is usually net debt (total debt minus cash). Subtracting it converts a whole-company figure into what common shareholders would receive after debt holders are paid. Dividing equity value by diluted shares outstanding gives an intrinsic value per share, which analysts compare against the market price to judge whether a stock looks cheap or expensive.
Strengths and limits of DCF
DCF values a company on its own fundamentals rather than on peer multiples, which makes it useful when comparable companies are scarce or mispriced. It forces explicit assumptions about growth, margins, and capital needs, which surfaces the drivers of value. In deal settings, the cash flow inputs are often normalized first through a quality of earnings report before they feed a DCF.
The limits are real. The output is highly sensitive to WACC and the terminal growth rate, so a defensible-looking model can produce a wide range of answers. Because 50% to 80% of value often sits in the terminal value, the number can hinge on an assumption about the distant future that no one can verify. Best practice is to run a sensitivity table across WACC and growth, use both terminal value methods, and treat the DCF as one input alongside comparable-company and precedent-transaction analysis, not a single point estimate.
Frequently asked questions
What is discounted cash flow in simple terms?
Discounted cash flow is a way to figure out what future money is worth today. You estimate the cash a business will generate over several years, then shrink each future amount to a present-day value using a discount rate, because money available sooner is worth more than the same amount later. Adding up those present values gives an estimate of what the business is worth now.
What discount rate should a DCF use?
An enterprise DCF that discounts unlevered free cash flow uses the weighted average cost of capital (WACC), the blended required return on the company’s debt and equity. A DCF that discounts levered free cash flow (cash to equity only) uses the cost of equity instead. The rate must match the cash flow, or the valuation will be internally inconsistent.
How do you calculate terminal value in a DCF?
Two methods are common. The Gordon growth method values cash flows beyond the forecast as a growing perpetuity: final-year free cash flow times (1 + g), divided by (WACC minus g), where g is typically 2% to 4%. The exit multiple method multiplies a final-year metric such as EBITDA by a market multiple from comparable companies. Analysts often run both to cross-check.
Why is terminal value such a large part of a DCF?
Terminal value covers every cash flow after the explicit forecast, which is an infinite horizon compressed into one figure, so it commonly represents 50% to 80% of total enterprise value. A 5-to-10-year forecast captures only the near term; the bulk of a going concern’s value lies in the years beyond it. This is why terminal value assumptions deserve heavy scrutiny and sensitivity testing.
What is the difference between enterprise value and equity value in a DCF?
Enterprise value is the value of the entire business to all capital providers, and it is what an unlevered DCF produces directly. Equity value is the portion belonging to shareholders. You bridge from one to the other by subtracting net debt and other claims: equity value equals enterprise value minus total debt plus cash, minus preferred stock and minority interest.
Is DCF better than using comparable company multiples?
Neither is strictly better; they answer different questions. DCF values a company on its own projected cash flows, useful when peers are scarce or mispriced, but it is sensitive to assumptions. Comparable-company and precedent-transaction analysis anchor value in observable market pricing but can carry market distortions. Most analysts use DCF alongside multiples and treat the range of results as the answer.
Reviewed by The Ledgerism Editorial Team. Last reviewed: July 2026.