DCF Valuation: The Complete Guide to Discounted Cash Flow Analysis

A DCF valuation (discounted cash flow valuation) estimates what a company is worth today by projecting its future cash flows and discounting them back to present value. It is the most widely used intrinsic valuation method in investment banking, equity research, and corporate finance because it values a business based on its own fundamentals rather than what the market says it’s worth.

If you’ve ever wondered how Goldman Sachs values a company for an acquisition, or how Warren Buffett decides whether a stock is cheap or expensive, the answer almost always involves a DCF. The method relies on a simple principle: a dollar today is worth more than a dollar tomorrow, because today’s dollar can be invested and earn a return. This is known as the time value of money.

This guide walks you through every step of building a DCF model, from forecasting free cash flows to calculating the discount rate to estimating terminal value. We’ll also cover the most common mistakes that destroy DCF accuracy, using lessons from over 30 years of professional valuation experience.

What Is DCF Valuation?

DCF valuation is a method of estimating the present value of an investment based on the cash flows it is expected to generate in the future. The core idea is straightforward: future cash flows are worth less than the same amount of cash today, so they must be “discounted” to reflect what they are worth right now.

The basic DCF formula is:

DCF Value = CF₁/(1+r)¹ + CF₂/(1+r)² + CF₃/(1+r)³ + … + CFₙ/(1+r)ⁿ + Terminal Value/(1+r)ⁿ

Where:

• CF = projected free cash flow for each period
• r = discount rate (typically WACC for enterprise DCF)
• n = number of projection periods
• Terminal Value = estimated value of all cash flows beyond the projection period

The output is called the intrinsic value, what the business is actually worth based on its ability to generate cash, independent of market sentiment or stock price fluctuations.

When to Use DCF Valuation

DCF works best when:

• The company has positive and predictable cash flows (or a clear path to profitability)
• You can reasonably forecast revenue, margins, and capital expenditure
• You want an absolute value rather than a relative comparison to peers

DCF is less reliable when:

• The company has no revenue or negative cash flows (early-stage startups)
• Cash flows are highly unpredictable (commodity companies, early-stage biotech)
• The company is in financial distress with an uncertain going-concern status

For companies where DCF is challenging, other valuation methods, such as comparable company analysis or precedent transactions, may be more appropriate, though experienced analysts often use DCF alongside these methods as a sanity check.

How to Build a DCF Model: Step-by-Step

Building a DCF model involves five core steps. Each step introduces inputs and assumptions that directly affect the final valuation, so precision and judgment at every stage matter enormously.

Step 1: Project Free Cash Flow

Free cash flow (FCF) is the cash a company generates after paying for operations and capital investments. It represents the cash available to return to all capital providers, both debt holders and equity holders.

There are two types of free cash flow used in DCF models:

Free Cash Flow to the Firm (FCFF):

FCFF = EBIT × (1 – Tax Rate) + Depreciation & Amortization – Capital Expenditures – Change in Working Capital

FCFF represents cash flow available to all capital providers (both debt and equity). When you discount FCFF by WACC, you get enterprise value. This is the most common approach in investment banking and is the variant used in Goldman Sachs’ valuation of Twitter.

Free Cash Flow to Equity (FCFE):

FCFE = Net Income + Depreciation – Capital Expenditures – Change in Working Capital + Net Borrowing

FCFE represents cash flow available to equity holders only. When you discount FCFE by the cost of equity, you get equity value directly. For a detailed comparison of when to use each, see our guide on which valuation method suits different company types.

Forecasting best practices:

• Project 5–10 years of explicit cash flows (5 years is standard for stable businesses; 10 for high-growth companies)
• Build revenue projections from the drivers, unit volume, pricing, and market share, not just top-line growth rates. Our Coca-Cola revenue analysis demonstrates why understanding what actually drives revenue matters more than extrapolating historical growth
• Be realistic about margins, one of the most common DCF mistakes is underestimating expenses and projecting unrealistic profit margins
• Account for the difference between growth capex and maintenance capex, failing to distinguish them leads to either overstated or understated free cash flows
• Understand the relationship between capex and depreciation to ensure capital investment assumptions are internally consistent

Step 2: Determine the Discount Rate (WACC)

The discount rate converts future cash flows into today’s dollars. For an enterprise DCF (using FCFF), the correct discount rate is the weighted average cost of capital (WACC).

WACC Formula:

WACC = (E/V × Kₑ) + (D/V × Kd × (1 – T))

Where:

• E/V = proportion of equity financing
• D/V = proportion of debt financing
• Kₑ = cost of equity
• Kd = cost of debt
• T = corporate tax rate

The optimal capital structure, the specific mix of debt and equity, determines the weights in WACC. In theory, there is a debt-to-equity ratio that minimizes WACC and maximizes firm value. In practice, as our analysis of WACC theory versus reality shows, companies don’t always operate at their theoretical optimum.

Calculating Cost of Equity (Kₑ)

The most common method to calculate the cost of equity is the Capital Asset Pricing Model (CAPM):

Kₑ = Rf + β × (Rm – Rf)

Where:

• Rf = risk-free rate, typically the 10-year government bond yield. Current rates are available from FRED (Federal Reserve Economic Data)
• β (beta) = a measure of the stock’s volatility relative to the market. Be careful with beta; using a raw, calculated beta is one of the top valuation mistakes because beta values vary significantly across measurement periods. Aswath Damodaran recommends using industry-average betas rather than company-specific calculated betas
• Rm – Rf = equity risk premium, the extra return investors demand for holding stocks over risk-free assets. Damodaran publishes regularly updated country risk premium data

Industry WACC benchmarks can be found in Damodaran’s cost of capital by industry dataset, which is updated annually and covers all US industries.

Step 3: Calculate Terminal Value

Terminal value estimates what the business is worth beyond your explicit forecast period. In most DCF models, terminal value accounts for 60–80% of the total enterprise value, making it the single most sensitive assumption.

There are two primary methods:

Perpetuity Growth Method (Gordon Growth Model):

Terminal Value = FCFₙ × (1 + g) / (WACC – g)

Where g is the perpetual growth rate (typically 2–3%, aligned with long-term GDP or inflation). This approach is a direct application of the Gordon Growth Model, which values an infinite stream of growing cash flows.

Exit Multiple Method:

Terminal Value = EBITDAₙ × Exit EV/EBITDA Multiple

This approach assumes the company is sold at the end of the projection period at a market-comparable multiple.

Terminal value pitfalls:

• Setting the perpetual growth rate above long-term GDP growth (2–3%) implies the company will eventually become larger than the economy
• Using an exit multiple that’s inconsistent with the growth and return assumptions baked into your DCF is internally contradictory
• For a deeper dive on terminal value calibration, see our guide on ROIC fading and terminal multipliers. It explains how return on invested capital should fade toward cost of capital over time, and how terminal multipliers should reflect that

Step 4: Discount to Present Value

Once you have projected cash flows and terminal value, discount everything back to today:

Enterprise Value = Σ (FCFₜ / (1 + WACC)ᵗ) + Terminal Value / (1 + WACC)ⁿ

This step is a direct application of the present value concept; every future dollar is worth less today because of the time value of money and risk.

Step 5: Bridge from Enterprise Value to Equity Value per Share

The DCF formula gives you enterprise value, the value of the entire business to all capital providers. To get to what the stock is actually worth:

Equity Value = Enterprise Value – Net Debt – Minority Interest – Preferred Equity + Cash & Equivalents

Equity Value per Share = Equity Value / Diluted Shares Outstanding

Compare this per-share value to the current stock price. If the intrinsic value is higher than the market price, the stock is theoretically undervalued.

DCF Valuation in Practice: Real-World Examples

Theory only gets you so far. Here’s how DCF works in professional settings:

How Investment Banks Use DCF

When J.P. Morgan evaluated Twitter for Elon Musk’s 2022 acquisition, they used DCF as one of three valuation methods alongside public trading multiples and precedent transactions. Our detailed analysis of J.P. Morgan’s Twitter valuation shows how bankers apply these methods in practice and why the DCF produced a different range than the market-based approaches.

Similarly, Goldman Sachs’ intrinsic value analysis of Twitter used a four-method approach that included DCF, illustrating that professional valuators never rely on a single method.

Applying DCF to Different Company Types

Not every company is a good DCF candidate:

• Stable, cash-generating businesses like Coca-Cola are ideal because their revenue drivers are analyzable, and margins are relatively predictable. See how we analyzed Coca-Cola’s revenue drivers to understand what actually generates cash
• Cyclical companies require normalized earnings rather than current-year numbers, using peak or trough earnings produces wildly inaccurate DCF results
• Declining companies pose unique challenges: negative growth rates, rising cost of capital, and terminal values that can turn negative
• Leveraged buyout targets require a modified DCF that models debt paydown and return-on-equity to PE sponsors

Learning From the Best: Damodaran’s DCF Framework

Aswath Damodaran, professor of finance at NYU Stern and arguably the world’s most respected valuation teacher, emphasizes five principles that should guide every DCF analysis. Our summary of Damodaran’s key insights on equity valuation covers his framework for using observable data, setting realistic growth assumptions, and keeping models simple enough to be useful.

The 7 Most Common DCF Valuation Mistakes

Even experienced analysts make these errors. Dr. Andrew Stotz has documented the most damaging valuation mistakes across 30+ years of professional practice:

1. Unrealistic Revenue and Margin Forecasts

The most common DCF mistake is projecting margins that are far more optimistic than what companies actually achieve. Global data shows net profit margins average just 5.5%, yet many analysts project 15–20% margins in their models. See the full analysis of this mistake.

2. Using Incorrect Beta

Beta drives the cost of equity, which drives WACC, which drives the entire DCF. Using a raw calculated beta is dangerous because the result changes dramatically depending on your measurement period, benchmark, and frequency. Learn why calculated beta is unreliable and what to use instead.

3. Terminal Value Dominance

When the terminal value represents more than 80% of the total DCF value, your model is essentially a one-number bet on long-term growth, not a rigorous cash flow analysis. Stress-test the terminal value by varying the growth rate and exit multiple times to see how sensitive the output is.

4. Ignoring Capital Intensity

Not distinguishing between growth capex and maintenance capex means your free cash flow projection doesn’t reflect the true cost of sustaining the business. Maintenance capex must continue even if growth stops.

5. Inconsistent Assumptions

If your revenue growth implies the company is becoming a market leader, but your margin assumptions imply it operates in a commodity market, those assumptions are internally contradictory. Every line in the model should tell a coherent story.

6. Neglecting Invested Capital Growth

Growth requires investment. If you project revenue growth without corresponding increases in invested capital, you’re implying the company grows for free, which doesn’t happen in reality. ROIC should inform how much capital is needed to fuel projected growth.

7. Skipping Sensitivity Analysis

A DCF model produces a single number, but every input is an estimate. Always run sensitivity tables on the key drivers: WACC (±1%), terminal growth rate (±0.5%), and revenue growth (±2–3%). Present a valuation range, not a point estimate.

DCF vs. Other Valuation Methods

Method	Approach	Best For	Limitation
DCF (Intrinsic)	Discounts projected cash flows	Companies with predictable cash flows	Highly sensitive to assumptions
Comparable Company Analysis	Values based on peer trading multiples	Quick relative valuation	Assumes peers are correctly valued
Precedent Transactions	Values based on past M&A deal multiples	M&A context	Historical deals may not reflect current conditions
Dividend Discount Model	Discounts future dividends	Mature, dividend-paying companies	Ignores non-dividend cash flows
Asset-Based Valuation	Values net assets on the balance sheet	Liquidation / holding companies	Ignores earnings power

Professional valuators at firms like Goldman Sachs and J.P. Morgan typically use DCF alongside at least one market-based method. The DCF provides a fundamentals-based anchor, while comparable analysis provides a market-reality check. For capital budgeting decisions, however, DCF (expressed as NPV or IRR) is often the sole framework used.

Key DCF Inputs: Where to Find the Data

Input	Source	Notes
Historical financials	SEC EDGAR (US), company annual reports	10-K for annual, 10-Q for quarterly
Risk-free rate	FRED — Treasury Yields	Use 10-year for most DCFs
Equity risk premium	Damodaran ERP Dataset	Updated annually, by country
Industry betas	Damodaran Beta Dataset	Unlevered betas by industry
Industry WACC	Damodaran WACC Dataset	By US industry sector
Peer multiples	Capital IQ, Bloomberg, or public filings	For exit multiple calibration
Risk factor research	Kenneth French Data Library	Fama-French factor data
General definitions	Investopedia — DCF, Wikipedia — DCF	Quick reference

Frequently Asked Questions

What is DCF valuation in simple terms?

DCF valuation estimates what a company is worth by projecting the cash it will generate in the future and then calculating what those future cash flows are worth today. It is based on the time value of money, the idea that money available now is worth more than the same amount received later, because today’s money can be invested. The result is called the company’s intrinsic value.

What discount rate should I use in a DCF?

For an enterprise DCF (using free cash flow to the firm), use the weighted average cost of capital (WACC). WACC blends the cost of equity calculated using the Capital Asset Pricing Model with the after-tax cost of debt, weighted by the company’s capital structure. For a quick benchmark, Damodaran publishes WACC by industry annually.

How many years should I project in a DCF?

The standard is 5 years for mature, stable businesses and up to 10 years for high-growth companies. The explicit forecast period should cover the time until the company reaches a steady-state growth rate. Beyond that, terminal value captures the remaining value using either the perpetuity growth method (based on the Gordon Growth Model) or an exit multiple.

What is the difference between FCFF and FCFE?

Free cash flow to the firm (FCFF) represents cash available to all capital providers, both debt and equity, and is discounted by WACC to arrive at enterprise value. Free cash flow to equity (FCFE) represents cash available only to equity holders and is discounted by the cost of equity to arrive at equity value directly. FCFF is more common in investment banking because it separates operating performance from capital structure decisions.

Why does terminal value dominate most DCFs?

Terminal value typically accounts for 60–80% of total DCF value because it captures all cash flows from year 6 (or year 11) to infinity, while the explicit forecast period only covers a few years. This concentration makes the terminal growth rate and exit multiple the most sensitive inputs in the model. Always run a sensitivity analysis on these assumptions.

Can DCF be used for startups or unprofitable companies?

DCF is difficult to apply when a company has no positive cash flows, because you’re essentially projecting when and if it will become profitable. For pre-revenue startups, investors typically use comparables, venture capital methods, or option pricing. However, for late-stage startups approaching profitability, a DCF with a longer projection period (10+ years) can work; you just need confidence in the path to positive cash flow.

Where can I learn DCF valuation hands-on?

The best way to learn DCF is by applying it to real companies, not just reading about it. The Valuation Master Class Boot Camp teaches you to build DCF models, value real companies, and produce professional equity research reports over 12 weeks of hands-on practice with expert feedback from Dr. Andrew Stotz, a former #1-ranked equity analyst.