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Discounted cash flow (DCF) estimates what expected future cash flows are worth today by discounting them at a rate that reflects their timing and risk. For a company, the common enterprise-value approach discounts free cash flow to the firm (FCFF) at WACC; the direct-equity approach discounts free cash flow to equity (FCFE) at the required return on equity.
A DCF is an assumption-driven estimate, not a guaranteed “true value.” Its usefulness depends on realistic cash-flow forecasts, a matching discount rate, and reasonable terminal-value assumptions.
What Is the DCF Formula?
The general formula is DCF value = Σ CFt / (1 + r)t, where CFt is the cash flow expected in period t, r is the discount rate, and t is the period in which the cash flow is received. Later cash flows are worth less today, all else equal. See the CFA Institute overview of free-cash-flow valuation.
For an enterprise DCF, add the present value of forecast FCFF to the present value of terminal value to estimate enterprise value. Then account for debt and other relevant claims, non-operating assets, and shares outstanding to estimate common equity value and value per share.
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Why money today is worth more than money in the future
Money available today can be invested, while inflation can reduce future purchasing power and uncertainty can make expected cash flows less certain. A discount rate reflects the required return for the cash flow being valued; it should not be treated as a generic penalty unrelated to that cash flow’s risk.
Present value in a simple example
If a hypothetical $100 cash flow is due in one year and the required annual return is 10%, its present value is $100 / 1.10, or about $90.91. A cash flow further in the future has a lower present value at the same rate.
Cash Flows and Discount Rates: FCFF vs. FCFE
Free cash flow is not automatically the same as net income, EBIT, EBITDA, or cash flow from operations. Analysts construct FCFF or FCFE from financial statements and assumptions about non-cash charges, investment, taxes, and financing. The cash-flow definition must match the discount rate and the value being estimated.
| Cash flow | Available to | Discount rate | Value produced |
|---|---|---|---|
| FCFF | Debt and equity capital providers | WACC | Enterprise value |
| FCFE | Common equity holders | Required return on equity | Equity value |
Common cash-flow construction formulas
One common FCFF formula from operating earnings is FCFF = EBIT × (1 − tax rate) + depreciation and other non-cash charges − fixed-capital investment − working-capital investment. From net income, a common construction is FCFF = net income + non-cash charges + interest × (1 − tax rate) − fixed-capital investment − working-capital investment.
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A common FCFE construction is FCFE = net income + non-cash charges − fixed-capital investment − working-capital investment + net borrowing. Net borrowing means debt issued less debt repaid. Definitions and adjustments should be consistent with the company’s statements and model. The CFA Institute valuation reading provides additional constructions using cash flow from operations and other starting points.
Choosing between FCFF and FCFE
FCFF is often practical when financing is changing or the analyst wants to value operations before financing claims. FCFE can be useful when leverage and borrowing assumptions are sufficiently predictable. With consistent assumptions, the approaches should produce compatible equity valuations.
How to Determine the Discount Rate
Use WACC to discount FCFF and the required return on equity to discount FCFE. WACC combines the required returns of debt and equity investors, weighted by their market values; its debt component is generally adjusted for the tax effect of interest where applicable.
A common CAPM estimate of the cost of equity is risk-free rate + beta × equity risk premium. Inputs such as beta, capital structure, and risk premiums involve judgment and estimation uncertainty.
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Cash-flow timing matters. For regularly spaced periods, the rate period must match the cash-flow period; convert an annual rate if modeling monthly or quarterly cash flows. For irregular dates, spreadsheet XNPV can account for actual dates, as described in the Corporate Finance Institute DCF guide.
How Do You Calculate Terminal Value?
Terminal value estimates cash flows beyond the explicit forecast period. As Tim Vipond of Corporate Finance Institute puts it, “Terminal value is the estimated value of a business beyond the explicit forecast period.” It is calculated at the end of the forecast period, then discounted back to the valuation date.
Perpetual growth method
For FCFF, the formula is TV = FCFFn × (1 + g) / (WACC − g). For an FCFE model, use terminal-year FCFE and the required return on equity instead. Here, g is sustainable perpetual growth and must be below the applicable discount rate. Choose a growth assumption that is economically supportable rather than treating a broad rule of thumb as a fact.
Exit multiple method
The exit-multiple method estimates terminal value as terminal-year financial metric × selected multiple, such as EBITDA multiplied by an assumed EV/EBITDA multiple. It imports a market-comparison assumption into the terminal estimate, so the multiple should be checked against relevant market evidence and the company’s expected maturity.
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The methods use different assumptions and can produce materially different estimates. Terminal value can make up a large share of DCF value, so test alternative growth rates, discount rates, or multiples. The Corporate Finance Institute terminal-value guide discusses both methods and sensitivity analysis.
DCF Calculation Walkthrough With Numbers
The following is a hypothetical enterprise-value example, not an observed valuation or investment recommendation. Assume FCFF of $100, $110, and $121 at the ends of years one through three, a 10% WACC, and terminal value of $1,500 at the end of year three.
- Discount year-one FCFF: $100 / 1.10 = $90.91.
- Discount year-two FCFF: $110 / 1.10² = $90.91.
- Discount year-three FCFF and terminal value together: ($121 + $1,500) / 1.10³ = approximately $1,218.63.
- Add the present values: approximately $90.91 + $90.91 + $1,218.63 = $1,400.45 enterprise value.
- To estimate common equity value, adjust enterprise value for debt and other relevant claims and non-operating assets. Divide by shares outstanding for an estimated value per share.
The total is approximate because of rounding. The example does not establish what discount rate, terminal growth rate, or market multiple is appropriate for any actual company.
Independent reader supportYour contribution helps us test, update, and keep practical guides available for everyone.Interpreting DCF Results and Common Limitations
Compare estimated intrinsic value with market price only in light of the assumptions used. A value above market price may indicate potential undervaluation under those assumptions; it does not prove that the market price is wrong. A margin of safety is a buffer against forecast error and uncertainty, not a guarantee against loss.
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Test the model with sensitivity analysis and coherent scenarios, varying key assumptions such as operating performance, reinvestment, discount rate, and terminal value. Compare the result with other valuation evidence rather than relying on a single point estimate.
When DCF works better—and when it works poorly
DCF is more informative when future cash flows can be estimated with reasonable confidence. It is less reliable when cash flows are highly volatile, negative, or difficult to forecast, including some innovative projects and growth companies. The Corporate Finance Institute DCF guide notes that other approaches, such as comparable analysis or precedent transactions, may be useful in such cases.
Frequent pitfalls include mixing FCFF with the cost of equity, mixing FCFE with WACC, confusing accounting earnings with free cash flow, and using inconsistent timing or nominal and real assumptions. Terminal-value assumptions also deserve scrutiny because they can strongly influence the output.
FAQ
What is the DCF formula?
DCF value is the sum of each expected cash flow divided by (1 + the discount rate) raised to the period in which it is received. Match the cash flow to the rate: FCFF with WACC, or FCFE with the required return on equity.
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How do you calculate terminal value?
Common methods are the perpetual-growth formula and the exit-multiple method. Calculate terminal value at the end of the explicit forecast period, then discount it to the valuation date.
How do you get from enterprise value to equity value?
Adjust enterprise value for debt and other relevant non-common-stock claims, and account for non-operating assets where appropriate. Divide the resulting common equity value by shares outstanding to estimate value per share.
Does a DCF give a precise intrinsic value?
No. It gives an estimate based on forecasts and assumptions. Sensitivity and scenario analysis help show how the result changes when important inputs change.
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