DCF Formula Explained
Master the Discounted Cash Flow valuation method used by Wall Street analysts
What is DCF Valuation?
Discounted Cash Flow (DCF) is a valuation method that estimates the value of an investment based on its expected future cash flows. The core principle is simple: a dollar today is worth more than a dollar tomorrow because of the time value of money.
DCF analysis is considered the gold standard of intrinsic value calculation because it focuses on the fundamental driver of value—free cash flow—rather than accounting metrics that can be manipulated.
The DCF Formula
Where:
- FCFₜ = Free Cash Flow in year t
- r = Discount rate (WACC)
- t = Year number
- TV = Terminal Value
- n = Number of projection years
Key Components of DCF
1. Free Cash Flow (FCF)
Free cash flow represents the cash a company generates after accounting for capital expenditures. It's the cash available to pay dividends, reduce debt, or reinvest in the business.
Alternative calculation:
FCF = EBIT × (1 - Tax Rate) + Depreciation - CapEx - Δ Working Capital
2. Discount Rate (WACC)
The Weighted Average Cost of Capital represents the company's cost of financing from both debt and equity. It's used to discount future cash flows to present value.
| Variable | Meaning | Typical Range |
|---|---|---|
| E/V | Equity weight | 50-80% |
| D/V | Debt weight | 20-50% |
| Re | Cost of equity (CAPM) | 8-15% |
| Rd | Cost of debt | 3-7% |
3. Terminal Value
Terminal value captures the value of all cash flows beyond the explicit forecast period. It often represents 60-80% of total DCF value.
Perpetuity Growth Method
g = perpetual growth rate (2-3%)
Exit Multiple Method
Multiple based on industry comparables
Step-by-Step DCF Calculation
Gather Historical Data
Collect 3-5 years of historical financial data including revenue, operating income, depreciation, capital expenditures, and working capital changes. This establishes the baseline for projections.
Project Future Free Cash Flows
Forecast FCF for 5-10 years based on:
- Historical growth rates
- Industry trends and TAM (Total Addressable Market)
- Competitive position and moat
- Management guidance and analyst estimates
Calculate WACC
Determine the appropriate discount rate using WACC. For cost of equity, use CAPM:
Rf = risk-free rate, β = beta, Rm = market return
Calculate Terminal Value
Apply the perpetuity growth formula with a conservative growth rate (typically 2-3%, not exceeding long-term GDP growth).
Discount to Present Value
Discount each year's FCF and the terminal value back to today:
Calculate Intrinsic Value Per Share
Sum all present values, add cash, subtract debt, and divide by shares outstanding:
Intrinsic Value = Equity Value / Shares Outstanding
DCF Example: Valuing a Company
Assumptions
FCF Projections
| Year | FCF ($M) | Discount Factor | Present Value ($M) |
|---|---|---|---|
| 1 | 575 | 0.917 | 527 |
| 2 | 661 | 0.842 | 557 |
| 3 | 760 | 0.772 | 587 |
| 4 | 874 | 0.708 | 619 |
| 5 | 1,005 | 0.650 | 653 |
| 6-10 | Years 6-10 at 8% growth | 2,450 | |
Terminal Value
PV of TV = $23,307M / (1.09)^10 = $9,847M
Final Valuation
Sensitivity Analysis
Small changes in WACC and terminal growth rate can significantly impact DCF results. Always run sensitivity analysis to understand the range of possible values.
| Terminal Growth Rate | |||||
|---|---|---|---|---|---|
| WACC | 1.5% | 2.0% | 2.5% | 3.0% | 3.5% |
| 8.0% | $171 | $183 | $198 | $216 | $240 |
| 8.5% | $155 | $165 | $176 | $190 | $208 |
| 9.0% | $142 | $150 | $152 | $170 | $183 |
| 9.5% | $130 | $137 | $145 | $154 | $164 |
| 10.0% | $120 | $126 | $133 | $140 | $149 |
DCF Limitations
Sensitive to Assumptions
Small changes in growth rate or WACC can dramatically change the result.
Difficult to Forecast
Predicting cash flows 5-10 years out is inherently uncertain.
Not Ideal for Early-Stage
Companies with negative or unpredictable cash flows are hard to value with DCF.
Terminal Value Dominance
60-80% of value often comes from terminal value, which is highly uncertain.
Calculate DCF Value Now
Use our free DCF calculator with real financial data for any stock.
Frequently Asked Questions
What is the DCF formula?
The DCF formula calculates intrinsic value by discounting projected future free cash flows back to their present value. The formula is: DCF = Σ(FCF / (1+r)^n) + Terminal Value / (1+r)^n, where FCF is free cash flow, r is the discount rate (WACC), and n is the year.
What discount rate should I use for DCF?
The most common discount rate is the Weighted Average Cost of Capital (WACC), typically ranging from 8-12% for most companies. Higher-risk companies warrant higher discount rates. Some investors use their required rate of return instead.
How do you calculate terminal value?
Terminal value can be calculated using the perpetuity growth method: TV = FCF × (1 + g) / (WACC - g), where g is the perpetual growth rate (typically 2-3%). Alternatively, use the exit multiple method: TV = EBITDA × Industry Multiple.
What is a good terminal growth rate?
A good terminal growth rate is typically between 2-3%, roughly in line with long-term GDP growth. Using a rate higher than economic growth implies the company will eventually become larger than the entire economy, which is unrealistic.
How many years should DCF projections cover?
DCF projections typically cover 5-10 years. Five years is common for stable companies, while 10 years may be used for high-growth companies. Beyond the explicit forecast period, terminal value captures remaining value.