# DCF Analysis

> Discounted cash flow & intrinsic value step by step

**Track:** Valuation  
**Read time:** 15 min

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Discounted cash flow (DCF) analysis is the gold standard of valuation. Its logic is disarmingly simple: any asset is worth the sum of the cash it will produce in the future, each cash flow discounted back to today at a rate reflecting its risk. Everything else in valuation — multiples, comps, rules of thumb — is a shortcut or sanity check on this core idea.

DCF is how investment banks value companies, how private equity screens deals, and how CFOs defend strategic investments. This guide walks the full pipeline: forecasting free cash flows, choosing the discount rate, estimating terminal value, and bridging from enterprise value to the equity number you actually compare with market prices.

## The Logic of DCF

DCF rests on the time value of money. A business is not worth what its assets cost or what someone once paid — it is worth the cash it will generate for its owners, adjusted for when and how reliably that cash arrives. Forecast the cash flows, discount them, add them up: that is intrinsic value.

The approach forces intellectual honesty. Unlike a multiple, which borrows value from comparable companies, DCF makes every assumption explicit — growth, margins, reinvestment, risk. You can argue with the assumptions, but they are visible. This is why DCF remains the framework of record despite its sensitivity, and why interviews and deal rooms always come back to "what discount rate, what growth, what terminal value?"

## Step 1 — Forecast Free Cash Flows

The standard valuation cash flow is unlevered free cash flow: cash generated by operations that is available to all capital providers, before financing choices. Start from revenue, project operating margins to get EBIT, apply taxes to get NOPAT, then add back non-cash charges and subtract reinvestment — capital expenditure and the working capital needed to support growth.

Forecasts usually cover 5–10 explicit years. The horizon should be long enough for the business to reach a steady state: growth converging toward sustainable levels, margins normalizing, and reinvestment matching depreciation. Extrapolating hypergrowth for twenty years is the classic beginner error — no company grows faster than the economy forever.

**Formula** — Unlevered free cash flow

```
FCF = EBIT × (1 − t) + D&A − CapEx − Δ Working Capital
```

> **A minimal forecast**
>
> A firm generates $100M EBIT, taxed at 25%, with $20M depreciation, $35M capex, and $5M working capital investment. FCF = 100 × 0.75 + 20 − 35 − 5 = $55M. Note the pattern: tax the operating profit, then adjust for accounting and reinvestment. Every serious model is this arithmetic at scale.

## Step 2 — Choose the Discount Rate

Because unlevered FCF belongs to all capital providers, it is discounted at the weighted average cost of capital (WACC) — the blended required return of lenders and shareholders. Discounting firm cash flows at the cost of equity would understate value; discounting at the cost of debt would overstate it. WACC is the matching principle in valuation.

The rate has enormous leverage over the answer: for a cash flow arriving in 20 years, moving the discount rate from 8% to 10% cuts its present value by roughly a third. Analysts therefore defend the WACC carefully — deriving the cost of equity from CAPM, the after-tax cost of debt from current yields, and the weights from market values, not book values.

**Formula** — Discounting the explicit forecast period

```
PV(FCF) = Σ_{t=1}^{n} FCF_{t} / (1 + WACC)^{t}
```

## Step 3 — Terminal Value

No one forecasts forever, so value beyond the explicit horizon is captured in a terminal value — usually the largest and most criticized number in the model. Two methods dominate. The Gordon growth method applies a growing perpetuity formula assuming cash flows grow at a modest rate g, typically 2–3%, close to long-run nominal GDP growth.

The exit multiple method instead applies an observable multiple (often EV/EBITDA of mature peers) to the final forecast year. Each method has failure modes: Gordon growth is hypersensitive to g relative to WACC, and exit multiples smuggle market sentiment into an intrinsic model. Prudent practice uses both, cross-checks the implied growth rates, and sanity-checks terminal value as a share of total value — often it is 60–75%, and more is a warning.

**Formula** — Gordon growth terminal value

```
TV = FCF_{n} × (1 + g) / (WACC − g)
```

## Step 4 — Enterprise Value to Equity Value

Summing discounted FCFs and terminal value yields enterprise value — the value of operations to all capital providers. To reach equity value, add non-operating assets such as excess cash and subtract net debt, minority interests, and other claims. Dividing by diluted shares outstanding gives per-share intrinsic value.

This bridge is where careless models go wrong. Cash that is operationally required should not be added back; debt should be measured at market value when possible; pension deficits and lease obligations are real claims. A model can be flawless in its forecasting and still mislead if the bridge double-counts or misses a claim.

**Formula** — The bridge to the share price

```
Equity Value = EV + Cash − Debt (± other claims)    Value per Share = Equity Value / Diluted Shares
```

## Step 5 — Sensitivity & Scenario Analysis

Because small input changes swing outputs, credible DCFs always present sensitivity tables — value across a grid of WACC and terminal growth assumptions — and scenarios that flex margins, growth, and capex together. The reader sees the range of defensible values rather than a false single point.

Good practice is to value, then argue. If the market price sits below your model’s range, ask what the market must be assuming that you are not, and whether your assumptions survive that test. DCF’s real product is not a number but a disciplined conversation about assumptions — and that is precisely why it remains the valuation workhorse.

- Present value ranges (WACC × terminal growth grids), never a single number.
- Cross-check terminal value share of total — 60–75% is common; more is a flag.
- Compare implied exit multiples against trading comps for consistency.
- Reverse-engineer: what growth does the market price imply?

## Key takeaways

- Intrinsic value = discounted future free cash flows — everything else is a shortcut.
- FCF = EBIT(1−t) + D&A − CapEx − ΔWC; discount unlevered FCF at WACC.
- Terminal value usually dominates the answer — handle with humility and cross-checks.
- Bridge EV to equity value carefully: cash in, net debt and claims out.
- Always present sensitivities; the output is a defensible range, not a point.

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