How to Perform a Discounted Cash Flow Valuation

A Discounted Cash Flow (DCF) valuation estimates the intrinsic value of a company by projecting its future cash flows and adjusting them for risk using a discount rate.

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How DCF Works

The idea behind DCF is simple:

• A business generates cash flow over time.
• Future cash flows are worth less than cash today because of risk and opportunity cost.
• The discount rate adjusts future cash flows to reflect their present value.
• The sum of all discounted cash flows gives an estimate of what the business is worth today.

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Free Cash Flow

There are multiple methods to calculate free cash flow:

From Cash Flow from Operations (simplest method):

FCF = Cash Flow from Operations (CFO) - Capital Expenditures (CapEx)

From EBIT:

FCF = (EBIT × (1 - Tax Rate)) + Depreciation + Amortization - Capital Expenditures - Change in Working Capital;

From Net Income:

FCF = Net Income + Interest × (1 - Tax Rate) + Depreciation - CapEx - Change in Working Capital;

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DCF Formula

To calculate a company’s value, sum up the present values of all future free cash flows (FCF):

DCF Value =  
FCF1 ÷ (1+r)^1 + 
FCF2 ÷ (1+r)^2 + 
FCF3 ÷ (1+r)^3 + 
FCF4 ÷ (1+r)^4 + 
FCF5 ÷ (1+r)^5 + 
Terminal Value ÷ (1+r)^5

or:

A. Growth Period = 
FCF1 ÷ (1+r)^1 + 
FCF2 ÷ (1+r)^2 + 
FCF3 ÷ (1+r)^3 + 
FCF4 ÷ (1+r)^4 + 
FCF5 ÷ (1+r)^5

B. Perpetual Growth (Gordon Growth Formula) = 
(FCF5 * (1 + g)) / (r - g)

C. Present Value of Perpetual Growth = 
B ÷ (1 + r)^5

DCF Value = A + C

Where:

• FCF: Free cash flow in the next projected year.
• g: Perpetual growth rate (e.g. GDP growth or 3-4%)
• r: Discount rate (e.g., WACC or cost of capital).
• Terminal value: Estimate of perpetual cash flows using Gordon Growth model.

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How to Perform a DCF Valuation

Step 1: Project & Discount Future Cash Flows

Project free cash flow (FCF) for some growth period (e.g. 5 years).

Example Cash Flow Projections at 5%:

Year	FCF ($M)	Formula
0	10.00	Starting value
1	10.50	10.00 * (1+0.05)^1
2	11.03	10.50 * (1+0.05)^2
3	11.58	11.03 * (1+0.05)^3
4	12.16	11.58 * (1+0.05)^4
5	12.76	12.16 * (1+0.05)^5

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Step 2: Choose a Discount Rate

The discount rate adjusts for risk and the time value of money. Typically:

• 6%-8% → Large, stable companies
• 8%-12% → Most businesses
• 12%+ → High-risk or early-stage businesses

Many investors use the Weighted Average Cost of Capital (WACC), which is the combined cost of debt + equity as weighted by their makeup of a company’s capital structure, but a fixed discount rate is often used for simplicity.

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Step 3: Calculate Perpetual Cash Flows

The Gordon Growth Model (GGM) is a simple formula to estimate the terminal value of a company,, assuming its cash flows grow at a constant rate forever.

Gordon Growth Formula:

TV = FCF / (r - g)

Where

• TV: Terminal value
• FCF: Free cash flow in the next projected year.
• g: Perpetual growth rate.
• r: Discount rate (e.g., WACC or cost of capital).

Perpetual Cash Flows Calculation:

• Year 6 FCF = 13.02 M (Yr 5 FCF: 12.76 × 1.02)
• Growth Rate (g) = 2%
• Discount Rate (r) = 8%
• Perpetual Cash Flows = 12.76 / (0.08 – 0.02) = 216.97M

*Perpetual cash flows have not been discounted yet.

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Step 4: Discount Perpetual Cash + Growth Value

All perpetual cash flows are discounted to present value (e.g. 8% discount rate):

A. Growth Period = 
10.50 ÷ (1+0.08)^1 + 
11.03 ÷ (1+0.08)^2 + 
11.58 ÷ (1+0.08)^3 + 
12.16 ÷ (1+0.08)^4 + 
12.76 ÷ (1+0.08)^5
= 43.82

B. Perpetual Growth (Gordon Growth Formula) = 
(12.76 * (1 + 0.02)) / (0.08 - 0.02) 
= 216.97

C. Present Value of Perpetual Growth = 
206.72 ÷ (1 + 0.08)^5 
= 147.66

DCF Value = 43.82 + 140.69 = 193.65

Year	FCF ($M)	PV ($M)
0	10.00	10.00
1	10.50	9.72
2	11.03	9.45
3	11.58	9.19
4	12.16	8.93
5	12.76	8.69
Terminal Value	216.97	147.66
TOTAL		193.65

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Conclusion

• DCF estimates the intrinsic value of a company by discounting all of its projected future cash flows to the present.
• The discount rate is subjective and impacts the valuation.
• Most of the value comes from the Terminal Value, so small assumption changes affect results significantly.