Discounted Cash Flow: How to Calculate What a Business Is Worth
Discounted cash flow values a business as the cash it will produce for its owners, converted into what that cash is worth today. Money arriving later is worth less than money in hand: at a 10% required return, $110 a year from now is worth $100 today, because $100 invested at 10% would become $110. A DCF applies that arithmetic to every year of a company's expected cash flow and adds the results together.
What a DCF is
A DCF estimates intrinsic value: the present value of the free cash flow a business generates, independent of what its shares trade for today. It requires three judgements — how much cash the business produces, for how long it keeps growing, and what return an investor should demand for taking the risk. The arithmetic is fixed; the judgements are where the work is.
The formula, with every variable defined
- FCFF — free cash flow to the firm: after-tax operating profit, plus depreciation, less capital expenditure and the increase in working capital. Cash available to every provider of capital before financing.
- t — the forecast year, discounted at year end.
- r — the discount rate. For FCFF this is the weighted average cost of capital, blending the cost of equity and after-tax cost of debt.
- n — the final explicit forecast year.
- g — perpetuity growth after year n. It must stay below r, and below long-run nominal economic growth.
Match the cash flow to the rate. FCFF discounts at WACC and gives enterprise value. Cash flow to equity discounts at the cost of equity and gives equity value directly. Mixing the two double-counts financing.
A worked example
A company expects free cash flow of $100m, $110m, $120m, $130m and $140m over five years. Its weighted average cost of capital is 10%, long-run growth after year five is 3%, it holds $50m of excess cash, carries $200m of debt and has 50m shares outstanding.
| Present value of the five forecast years | $447.70m |
| Terminal value at the end of year five | $2,060.00m |
| Present value of the terminal value | $1,279.09m |
| Enterprise value | $1,726.79m |
| Plus excess cash, less debt | +$50m / −$200m |
| Equity value | $1,576.79m |
| Value per share (50m shares) | $31.54 |
| Terminal value as a share of enterprise value | 74.1% |
Raise the discount rate from 10% to 11% and the same forecast is worth $27.11 per share — 14% lower, with no change to a single cash flow. Three-quarters of the value sits in the terminal period, which is why the discount rate and terminal growth dominate the answer.
Try it with your own numbers
For the operating-driver version, the sensitivity table and an Excel download, use the working DCF model.
How to choose the inputs
- Cash flow. Start from filed statements, not a target. Strip one-off items, and check whether recent capital spending supports the growth you are forecasting.
- Discount rate. Build WACC from the actual capital structure: cost of equity from a risk-free rate plus a risk premium scaled to the business, cost of debt from what the company actually pays, weighted at market values.
- Terminal growth. A business cannot outgrow the economy forever. Long-run nominal GDP growth is the practical ceiling.
- Net debt and cash. Use excess cash, not every dollar on the balance sheet — operating cash is already funding the business.
- Share count. Diluted, including awards likely to vest.
Why valuations change
A DCF output moves for two different reasons, and keeping them apart is the difference between research and noise. The first is new information about the business: an order book, a margin, a capital programme. The second is a change in the required return, which repriced nothing about the company itself. A valuation that falls because rates rose is telling you something very different from one that falls because demand did.
What could change this valuation?
Reported developments on the left. The assumption they invite you to re-examine, and the recalculated result, on the right. The size of each change is your judgement.
Policy rates move higher across the curve
Teaching example · Used when no tracked development maps to a valuation assumption.
Cost of capital
Only part of a policy move reaches a company's weighted cost of capital. The pass-through depends on the debt mix, refinancing schedule and equity risk premium, so the size below is your judgement, not an arithmetic consequence.
Long-run growth expectations are revised down
Teaching example · Used when no tracked development maps to a valuation assumption.
Terminal growth
Terminal growth should stay at or below long-run nominal economic growth. Small revisions here move most of the value because the terminal period carries most of it.
Input costs rise and are not passed to customers
Teaching example · Used when no tracked development maps to a valuation assumption.
Forecast free cash flow
Margin pressure shows up in the forecast period rather than the discount rate. Check whether the company has repriced before assuming it cannot.
Capital spending steps up ahead of revenue
Teaching example · Used when no tracked development maps to a valuation assumption.
Forecast free cash flow
Spending ahead of revenue lowers near-term free cash flow without necessarily changing the terminal value. Whether it raises later cash flow is the question worth answering.
Common mistakes
- Terminal growth set at or above the discount rate, which has no finite answer.
- Discounting levered cash flow at WACC, double-counting the financing.
- Forecasting margin expansion with no capital spending to support it.
- Treating all balance-sheet cash as excess cash.
- Reverse-engineering the inputs until the output matches the market price.
- Ignoring how much of the value sits in the terminal period before reporting a precise-looking number.
Apply the method
The arithmetic above is the easy part. Applying it to a real company means pulling filed statements, building the forecast from segment economics, and knowing which assumptions to revisit when something changes. That is what the equity valuation workspace does, with the filings, the price and the assumption history attached.
Build a DCF model for your company