Fundamental analysisModule 6, lesson 31 of 48
Discounted cash flow valuation
How to build a simple DCF valuation: forecast free cash flow, discount it, add a terminal value, and move from enterprise value to value per share.
In this lesson
- Forecast free cash flow to the firm from revenue, margins, tax, investment and working capital.
- Discount the forecast cash flows at WACC.
- Add a terminal value and calculate enterprise value.
- Move from enterprise value to equity value and value per share.
Builds on
- Weighted average cost of capital (WACC)The forecast cash flows are discounted at WACC, explained there.
- Free cash flow and cash conversionA DCF values the free cash flow a business generates.
On this page
In simple terms
A discounted cash flow (DCF) valuation puts the idea of intrinsic value into practice. It estimates the cash a business will generate in future, converts each year's cash into today's money using a discount rate, and adds it all up.
The method has five steps:
- Forecast free cash flow for a number of years, often five to ten.
- Discount each year's cash flow to today.
- Estimate a terminal value for all the years after the forecast.
- Add them to get the enterprise value of the business.
- Subtract net debt and divide by the number of shares to get value per share.
Step 1: forecasting free cash flow
This lesson uses free cash flow to the firm (FCFF), the cash available to both lenders and shareholders:
FCFF = EBIT × (1 − tax rate) + depreciation − capital expenditure − increase in working capital
Each line needs a forecast, built from your understanding of the business:
- Revenue growth: based on the industry, the company's position and its history, as the growth lesson explains. Growth usually slows over time.
- Operating margin: based on history, peers and competitive position.
- Tax rate: the company's effective rate, adjusted for anything unusual.
- Capital expenditure and depreciation: linked to the growth you forecast; faster growth needs more investment.
- Working capital: typically a percentage of the increase in revenue.
Keep the forecast consistent. Fast growth with low investment, or rising margins in an intensely competitive industry, are warning signs that the assumptions do not hang together.
Step 2: discounting
Discount each year's FCFF at the WACC, as the present value lesson shows.
Step 3: terminal value
A business does not stop after five years. The terminal value captures the value of all cash flows beyond the forecast. The most common method assumes cash flows grow at a steady rate for ever:
terminal value = FCFF in the final year × (1 + long-run growth) ÷ (WACC − long-run growth)
The terminal value is measured at the end of the forecast period, so it must also be discounted back to today. The terminal value lesson covers the method and its limits.
Steps 4 and 5: from enterprise value to value per share
Adding the discounted cash flows and the discounted terminal value gives the enterprise value. To reach the value of the shares, subtract what belongs to others:
equity value = enterprise value − borrowings − other debt-like claims + cash and non-operating investments value per share = equity value ÷ number of shares (diluted)
A worked example
Worked example: A made-up company
Pragati Components. The forecast free cash flow to the firm, WACC of 11% and long-run growth of 5% are all assumptions for this example.
| Year 1 FCFF ₹100 crore ÷ 1.11 | ₹90.1 crore |
|---|---|
| Year 2 FCFF ₹115 crore ÷ 1.11^2 | ₹93.3 crore |
| Year 3 FCFF ₹130 crore ÷ 1.11^3 | ₹95.1 crore |
| Year 4 FCFF ₹145 crore ÷ 1.11^4 | ₹95.5 crore |
| Year 5 FCFF ₹160 crore ÷ 1.11^5 | ₹95.0 crore |
| Present value of years 1 to 5 | ₹468.9 crore |
| Terminal value at year 5: 160 × 1.05 ÷ (0.11 − 0.05) | ₹2,800 crore |
| Present value of terminal value: 2,800 ÷ 1.11^5 | ₹1,661.7 crore |
| Enterprise value: 468.9 + 1,661.7 | ₹2,130.6 crore |
| Less net debt (borrowings ₹700 crore − cash ₹200 crore) | ₹500 crore |
| Equity value | ₹1,630.6 crore |
| Value per share, 50 crore shares | about ₹32.60 |
Notice that the terminal value provides 1,661.7 ÷ 2,130.6, about 78% of the enterprise value. Most of what this DCF says depends on the assumptions about the years after year 5.
A detailed model is not an accurate one
DCF spreadsheets can grow to hundreds of lines, with every cost forecast separately. Detail can help you think through the business, but it does not make the future more predictable. The value still rests on a handful of big assumptions: long-run growth, long-run margins, investment needs and the discount rate. Small changes in these move the result far more than any detail elsewhere.
That is why a DCF should always be accompanied by sensitivity and scenario analysis, and why it is worth comparing the result with relative valuation and with what the market price implies.
Why it matters
A DCF forces you to state your assumptions about a business explicitly and to check that they fit together. It shows which assumptions matter most. Even if you never rely on the final number, building one teaches you what has to go right for a company to justify its price.
Limitations
A DCF depends on forecasts that may be wrong, a discount rate that is a judgement, and a terminal value that dominates the result. It works poorly for companies with very uncertain or negative cash flows, and it is not suitable in this form for banks and insurers, whose debt is part of operations. Its output is a range, not a fact.
Common mistakes
- Forgetting to discount the terminal value.
- Inconsistent assumptions, such as high growth with little investment.
- Mixing firm cash flows with the cost of equity, or equity cash flows with WACC.
- Forgetting debt-like items and dilution when moving to value per share.
- Treating the result as precise.
Try it yourself
Using your notes from the earlier lessons in this module, build a simple five-year DCF for a listed company.
- Start from last year's revenue, operating margin, tax rate, capital expenditure and depreciation.
- Forecast each for five years, keeping them consistent.
- Discount at a WACC you can justify, add a terminal value with long-run growth no higher than you expect the economy to grow, and subtract net debt.
- Compare your value per share with the market price, and note which assumptions you are least sure about.
Key takeaways
- A DCF values a business as the present value of the free cash flow it will generate, discounted at a rate that reflects the risk.
- The steps are to forecast free cash flow for several years, discount it, add a terminal value for the years beyond, subtract net debt, and divide by the number of shares.
- Free cash flow to the firm is operating profit after tax, plus depreciation, minus capital expenditure and minus the increase in working capital.
- The terminal value is usually most of the result, so its assumptions deserve the most care.
- A DCF is only as good as its assumptions. A detailed spreadsheet does not make a forecast accurate.
Check your understanding
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Terms used in this lesson
- Discounted cash flow
- A valuation method that estimates a business's worth as the present value of the free cash flow it will generate.
- Free cash flow
- Cash from operating activities minus capital expenditure. The cash left for lenders and owners after keeping the business running.
- WACC
- The average return required by all of a company's providers of capital, weighting the cost of equity and the after-tax cost of debt.
- Terminal value
- In a DCF, the value of all cash flows after the explicit forecast period, often the largest part of the valuation.
- Enterprise value
- Market capitalisation plus debt minus cash, an estimate of the value of the whole operating business owed to lenders and shareholders.
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This lesson is general education, not investment advice. Examples use made-up or clearly dated figures to explain ideas; they are not recommendations. Read the disclaimer.