How to build and read a DCF
A discounted cash flow model values a business as the present value of all the cash it will generate in future. It's the most fundamental valuation method, and also the easiest to fool yourself with.
Step 1: forecast free cash flow
Usually five to ten years, built from revenue growth, margins, tax, reinvestment (capital expenditure) and working capital. For a company-wide (enterprise) DCF, use unlevered free cash flow: cash generated before paying lenders or shareholders.
Step 2: the terminal value
You can't forecast forever, so the value of everything after the forecast period is captured in one number:
Terminal value = final year FCF × (1 + g) ÷ (WACC − g)
g is the long-term growth rate, usually close to long-run economic growth (around 2-3%). Alternatively, apply an exit multiple, such as a typical EV/EBITDA.
Step 3: discount and add up
Discount each year's cash flow and the terminal value back to today at the WACC (lessons 6.1 and 6.2) and add them up. That gives enterprise value. Subtract net debt to get equity value, then divide by the diluted share count for value per share.
Reading someone else's DCF
- How much is terminal value? If it's 80% of the answer, the result depends mostly on assumptions about the distant future.
- Are margins realistic? Compare them with history and the best competitors.
- Is growth consistent with reinvestment? Fast growth with little capex is a red flag.
- Is g below WACC and sensible? A growth rate above long-term GDP implies the company eventually becomes the economy.
Sensitivity
Always show a table of values across a range of WACC and growth assumptions. A 1 point change in WACC can move value by 20% or more. The real output of a DCF is a range, and an understanding of which assumptions the price is implying.
Reverse DCF
Instead of asking what a company is worth, ask what growth and margins the current share price assumes. If the market is pricing in 25% growth for a decade, you can judge whether that is plausible. Often this is more useful than a target price.
Key takeaway
A DCF is a structured way to think about a business, not a machine that produces the truth. Its value is in making every assumption explicit and testable.
Educational content only, not financial advice. Investing involves risk and you can lose money.