TL;DR. A discounted cash flow (DCF) model values a company as the present value of the free cash flow it is expected to generate, discounted back at a rate that reflects the time value of money and the riskiness of those cash flows. Three inputs do almost all of the work: the cash flow trajectory, the discount rate, and the terminal value assumption. Get those wrong and the answer is wrong, no matter how many cells the model has.
The core formula
The textbook DCF formula sums the present value of each year’s free cash flow plus the present value of a terminal value:
Enterprise Value = Σ [ FCFt / (1 + r)t ] + [ TVn / (1 + r)n ]
The components are straightforward, but each one hides judgment calls:
- FCFt is free cash flow to the firm in year t — operating cash flow minus capital expenditures, before financing. Corporate Finance Institute presents the same setup.
- r is the discount rate, almost always the firm’s weighted average cost of capital (WACC).
- TVn is the terminal value — the lump-sum worth of every cash flow after the explicit forecast ends. The most common method is the Gordon Growth Model: TVn = FCFn × (1 + g) / (r − g), where g is the perpetual growth rate. Corporate Finance Institute’s Gordon Growth note spells out the same formula and the constraint that g must be strictly less than r.
The output, enterprise value, is what the operating business is worth before financing. To get to an equity value per share, subtract net debt and minority interest, add back non-operating assets, and divide by diluted shares outstanding.
Where DCF sits in the toolkit
DCF is one of three main valuation lenses. The other two — trading multiples like P/E and EV/EBITDA, and precedent-transaction multiples — ask the market what comparable companies are worth right now. DCF, by contrast, asks what the cash flows themselves are worth on first principles.
The advantage: DCF forces you to write down every assumption. The disadvantage: those assumptions compound. Two analysts with the same model and slightly different views of growth and risk can produce values 30–50% apart and both be defensible.
A worked example
Imagine a company expected to produce $100 million of free cash flow next year, growing 8% per year for five years and then 2.5% in perpetuity. Its WACC is 9%. It carries $200 million of net debt and has 100 million shares outstanding.
| Year | Free Cash Flow ($M) | Discount Factor | Present Value ($M) |
|---|---|---|---|
| 1 | 100.00 | 0.9174 | 91.74 |
| 2 | 108.00 | 0.8417 | 90.90 |
| 3 | 116.64 | 0.7722 | 90.07 |
| 4 | 125.97 | 0.7084 | 89.24 |
| 5 | 136.05 | 0.6499 | 88.42 |
| Terminal | 2,145.4 | 0.6499 | 1,394.5 |
| Enterprise Value | 1,844.9 |
Subtract $200 million of net debt and divide by 100 million shares: equity value works out to $16.45 per share. Notice something striking: the five explicit forecast years contributed $450 million to enterprise value, while the terminal value contributed $1,395 million. The post-forecast period is worth more than three times the period we actually modeled.
The three inputs that really matter
1. The discount rate
WACC blends the cost of equity and the after-tax cost of debt, weighted by their share of the capital structure. Most analysts build the cost of equity from the Capital Asset Pricing Model: risk-free rate plus beta times the equity risk premium. The risk-free rate is anchored to a long-dated government bond yield — for U.S. companies, typically the 10-year Treasury. As of May 21, 2026, the Federal Reserve’s H.15 release put the 10-year Treasury constant-maturity yield at 4.57%.
A one-percentage-point change in WACC can move a DCF value by 15–20%. That is why analysts pay obsessive attention to beta, capital structure, and the equity risk premium — minor input changes have major output effects.
2. The terminal growth rate
The terminal growth rate g represents how fast cash flows will grow forever after the explicit forecast period. The hard constraint: g must be less than r, or the Gordon Growth formula produces nonsense (the denominator goes to zero or negative). In practice, g should also be less than the long-run nominal growth rate of the economy the company operates in — otherwise the company eventually becomes bigger than the economy, which cannot happen indefinitely.
A useful sanity check: for a U.S. company, a terminal growth rate above the 10-year Treasury yield is a bright red flag. Mature businesses typically sit at 2–3%; high-growth franchises occasionally justify 3–4% if the duration of competitive advantage is long.
3. The cash flow trajectory
Garbage in, garbage out. Optimistic revenue, margin, and capex assumptions produce optimistic DCFs. The discipline is to model unit economics — revenue per customer, customer count, margins by segment — rather than top-line CAGR. And then to stress-test: what happens if growth is half of plan? If margins compress 200 basis points? A DCF without a sensitivity table is a single guess dressed up as math.
Sensitivity: the same model, four very different answers
The table below recomputes the equity value per share from the worked example, varying WACC and terminal growth. Each cell uses the same FCF trajectory and the same Gordon Growth terminal-value method. The only differences are r and g.
| Equity value per share | g = 1.5% | g = 2.0% | g = 2.5% | g = 3.0% |
|---|---|---|---|---|
| WACC = 8% | $17.09 | $18.37 | $19.89 | $21.70 |
| WACC = 9% | $14.47 | $15.39 | $16.45 | $17.68 |
| WACC = 10% | $12.47 | $13.15 | $13.93 | $14.81 |
| WACC = 11% | $10.89 | $11.42 | $12.00 | $12.66 |
From $10.89 to $21.70 — the same business, the same forecast, only the rate and the long-run growth assumption changing. That is a 99% range, and every cell in the table is defensible. This is why sell-side analysts almost always present DCF as a range, not a point estimate, and why “the DCF says it is worth X” should always be followed by “under these assumptions.”
Common mistakes that quietly break a DCF
- Terminal value above 90% of EV. If your model’s value is almost entirely terminal, you are not really doing a DCF — you are doing an exit-multiple valuation with extra steps. Stretch the forecast period to push the terminal further out, or accept that you are guessing about the long run.
- Setting g close to r. The denominator (r − g) goes to zero and terminal value explodes. A model that says a company is worth $100 billion at g = 4% and $400 billion at g = 5% is showing you that the long-run growth assumption, not the business, is doing the work.
- Mismatched cash flows and discount rate. Free cash flow to the firm is discounted at WACC. Free cash flow to equity is discounted at the cost of equity. Mix them up and the answer is meaningless. (See our FCF explainer for the difference.)
- Forgetting reinvestment. A company growing at 5% perpetually cannot do so with zero capex; growth costs money. If terminal growth is 3%, capex must remain at a level that supports it.
- Stacking optimistic assumptions. Aggressive revenue, expanding margins, falling tax rate, and a low discount rate — each plausible individually — multiply into an indefensible answer.
When DCF is the wrong tool
DCF works best when cash flows are knowable: mature consumer brands, regulated utilities, infrastructure. It strains for early-stage companies with negative cash flow, cyclical commodity producers whose cash flow depends on a price you cannot forecast, financial institutions whose “free cash flow” concept is murky, and option-rich businesses where most of the value is the right to invest later. For those, a multiples cross-check, a sum-of-the-parts analysis, or a real-options framework usually serves better.
Related concepts and what to learn next
Reading these alongside this article gives you the full valuation stack:
- What Is Free Cash Flow — and Why Investors Trust It — the input
- Beta, Alpha, and CAPM — how cost of equity is built
- Enterprise Value Explained — the bridge from EV to equity
- What Is the P/E Ratio — and When Does It Mislead? — the multiples cross-check
Sources
- Corporate Finance Institute — DCF Formula Guide
- Corporate Finance Institute — Gordon Growth Model
- Federal Reserve H.15 Selected Interest Rates — 10-year Treasury yield 4.57% as of May 21, 2026
- Aswath Damodaran (NYU Stern) — Valuation resources
- SEC — A Beginner’s Guide to Financial Statements
Disclosure: This article was produced with AI assistance and reviewed before publication. It is for informational purposes only and is not investment advice.