Valuation
What is a DCF?
A discounted cash flow — a DCF — is the most fundamental way to value a company: forecast the cash it will generate, then discount that cash back to what it’s worth today. It’s the model behind much of professional valuation.
Where the P/E ratio is a quick shortcut, a DCF is the ground-up approach: it values a company on the actual cash it's expected to produce, rather than on what the market is currently paying. It's built directly on the time value of money — the idea that future cash is worth less than cash today.
The five steps
A DCF always runs in the same order:
- 1. Forecast the cash flows — project the company's free cash flow for an explicit period, usually five to ten years.
- 2. Estimate a terminal value — a single figure capturing all the cash flows beyond the forecast period.
- 3. Discount everything to today — bring each year's cash flow, and the terminal value, back to present value.
- 4. Sum them — the total is the enterprise value (the value of the whole firm).
- 5. Bridge to a share price — adjust to equity value and divide by the shares.
Discounting the cash flows
Each forecast year's cash flow is discounted using the WACC — the company's blended cost of capital — as the discount rate. Cash further in the future is worth less today, so later years are discounted more heavily. The terminal value, which sits at the end of the forecast, is discounted back too. Add all the present values together and you get the enterprise value.
From enterprise value to a share price
Enterprise value is the value of the whole business, to all its investors. To get to what the shares are worth, you subtract net debt (debt minus cash) to reach equity value — debt is a claim that ranks ahead of shareholders, while cash is an asset you add back. Divide equity value by the number of shares and you have an implied value per share. Compare it to the market price: higher suggests the stock is undervalued; lower, overvalued — according to your assumptions.
Garbage in, garbage out
Here's the honest caveat every analyst learns. A DCF is only as good as its inputs, and two of them — the terminal value and the WACC — dominate the answer. Small changes in either can swing the valuation dramatically. That's why professionals never trust a single number; they run sensitivity tables across a range of assumptions and treat the output as a range of plausible values, not a precise truth.
Key takeaways
- A DCF values a company on its future cash, discounted to today.
- Five steps: forecast, terminal value, discount, sum, bridge to a share price.
- The discount rate is the WACC; later cash flows are discounted more.
- Terminal value and WACC dominate — treat the result as a range, not a fact.
Common questions
What is a DCF in simple terms?
What are the steps in a DCF?
What discount rate is used in a DCF?
Why is a DCF considered unreliable?
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