Discounted Cash Flow (DCF) analysis is the gold standard of stock valuation methods. Used by investment bankers, equity analysts, and value investors, DCF calculates what a business is truly worth by projecting its future cash flows and discounting them back to present value. This guide walks you through the complete DCF process with real calculations.
What is DCF Valuation?
DCF valuation answers a fundamental question: What is a company worth based on the cash it will generate in the future? The concept is simple but powerful - a dollar today is worth more than a dollar tomorrow because you can invest today's dollar and earn a return.
Core principle: A company's intrinsic value equals the present value of all future free cash flows it will generate, discounted at an appropriate rate that reflects the risk of those cash flows.
The DCF Formula
The basic DCF formula is:
Intrinsic Value = Sum of (FCF / (1 + r)^n) + Terminal Value / (1 + r)^n
Where:
- FCF = Free Cash Flow in each projected year
- r = Discount rate (usually WACC)
- n = Number of years in the future
- Terminal Value = Value of all cash flows beyond the projection period
Step 1: Project Free Cash Flows
Free Cash Flow (FCF) represents cash available to all capital providers after the company has paid its operating expenses and made necessary capital investments.
FCF Formula: Operating Cash Flow - Capital Expenditures
Or more detailed:
FCF = EBIT x (1 - Tax Rate) + Depreciation - Capital Expenditures - Change in Working Capital
Example: Projecting FCF
Assume Company XYZ has these current figures:
- Current Free Cash Flow: $500 million
- Expected FCF growth: 15% for years 1-5, then 10% for years 6-10
| Year | Growth Rate | FCF (millions) |
|---|---|---|
| 1 | 15% | $575 |
| 2 | 15% | $661 |
| 3 | 15% | $760 |
| 4 | 15% | $874 |
| 5 | 15% | $1,005 |
Step 2: Determine the Discount Rate (WACC)
The Weighted Average Cost of Capital (WACC) represents the blended cost of all capital sources and serves as the discount rate in DCF analysis.
WACC Formula:
WACC = (E/V x Re) + (D/V x Rd x (1 - Tc))
- E = Market value of equity
- D = Market value of debt
- V = E + D (total capital)
- Re = Cost of equity
- Rd = Cost of debt
- Tc = Corporate tax rate
Cost of Equity Calculation (CAPM)
Re = Risk-Free Rate + Beta x (Market Return - Risk-Free Rate)
Example: If risk-free rate is 4%, beta is 1.2, and expected market return is 10%:
Re = 4% + 1.2 x (10% - 4%) = 4% + 7.2% = 11.2%
Step 3: Calculate Terminal Value
Since we cannot project cash flows forever, we calculate terminal value to capture all value beyond our projection period. Two common methods:
Perpetuity Growth Method
Terminal Value = Final Year FCF x (1 + g) / (WACC - g)
Where g = perpetual growth rate (usually 2-3%, similar to GDP growth)
Example: Year 5 FCF of $1,005M, WACC of 10%, perpetual growth of 2.5%:
TV = $1,005 x 1.025 / (0.10 - 0.025) = $1,030 / 0.075 = $13,733 million
Exit Multiple Method
Terminal Value = Final Year EBITDA x Exit Multiple
Example: Year 5 EBITDA of $1,500M with 10x exit multiple:
TV = $1,500 x 10 = $15,000 million
Step 4: Discount Everything to Present Value
Now discount each year's FCF and the terminal value back to today:
Present Value = Future Value / (1 + WACC)^n
| Year | FCF | Discount Factor (10%) | Present Value |
|---|---|---|---|
| 1 | $575 | 0.909 | $523 |
| 2 | $661 | 0.826 | $546 |
| 3 | $760 | 0.751 | $571 |
| 4 | $874 | 0.683 | $597 |
| 5 | $1,005 | 0.621 | $624 |
| Terminal Value | $13,733 | 0.621 | $8,528 |
| **Total** | **$11,389** |
Step 5: Calculate Intrinsic Value Per Share
To get the per-share value:
- Start with Enterprise Value from DCF: $11,389 million
- Add cash and equivalents: + $500 million
- Subtract total debt: - $2,000 million
- Equity Value = $9,889 million
- Divide by shares outstanding: 100 million shares
- Intrinsic Value = $98.89 per share
Investment decision: If the stock currently trades at $75, the DCF suggests it is undervalued by about 32%. If it trades at $120, it may be overvalued by about 21%.
Sensitivity Analysis
DCF results are highly sensitive to assumptions. Always test different scenarios:
| WACC / Growth | 2.0% | 2.5% | 3.0% |
|---|---|---|---|
| 9% | $112 | $125 | $142 |
| 10% | $89 | $99 | $110 |
| 11% | $72 | $79 | $87 |
Limitations of DCF Analysis
- Highly dependent on assumptions: Small changes in growth or discount rates create large value swings
- Difficult for unpredictable businesses: Cyclical companies and startups are hard to model
- Terminal value dominance: Often 60-80% of value comes from terminal value
- Requires significant research: Quality inputs require deep fundamental analysis
Track Your Value Investments
Pro Trader Dashboard helps you monitor your portfolio and track how your DCF-based investment decisions perform over time.
When to Use DCF
DCF works best for:
- Mature companies with predictable cash flows
- Companies with stable or growing free cash flow
- Long-term investment decisions
- Merger and acquisition valuations
Summary
DCF valuation is a powerful tool that estimates intrinsic value based on projected future cash flows discounted to present value. The five key steps are: project free cash flows, determine the discount rate (WACC), calculate terminal value, discount everything to present value, and derive per-share value. While DCF requires significant assumptions and research, it provides a rigorous framework for understanding what a business is truly worth independent of market sentiment.
Related reading: calculating intrinsic value, margin of safety, and fundamental analysis guide.