How a DCF works
A discounted cash flow (DCF) valuation says a business is worth the cash it will generate in future, translated into today’s money. Cash arriving later is worth less than cash today, both because money has a time value and because the future is uncertain, so each year’s cash flow is divided by (1 + discount rate) raised to the number of years away it is.
value today = FCF1÷(1+WACC) + FCF2÷(1+WACC)2 + … + terminal value÷(1+WACC)N
This calculator uses a common two-stage model. Free cash flow grows at your chosen rate for a set number of years, then at a slower terminal rate forever. The terminal value captures everything after the forecast period:
terminal value = FCFN × (1 + terminal growth) ÷ (WACC − terminal growth)
Building the discount rate: WACC
The discount rate is the return investors require to fund the business. For a company financed by both shareholders and lenders, that is the weighted average cost of capital (WACC):
WACC = E÷(D+E) × cost of equity + D÷(D+E) × cost of debt × (1 − tax rate)
- Cost of equity comes from the capital asset pricing model: risk-free rate + beta × equity risk premium. Use the yield on a long-dated government bond for the risk-free rate, and an equity risk premium in the range most practitioners use, commonly 4–6%.
- Cost of debt is what the company pays to borrow, reduced by the tax rate because interest is usually tax-deductible.
- The weights use market values: market capitalisation for equity and total debt for lenders.
A worked example
Free cash flow of 1,000 (in millions, say), growing 8% a year for five years, then 2.5% forever. The risk-free rate is 4.2%, beta 1.1 and the equity risk premium 5%, so the cost of equity is 4.2% + 1.1 × 5% = 9.7%. Debt costs 6% before a 25% tax rate, or 4.5% after it. With 20,000 of equity and 5,000 of debt, WACC is 0.8 × 9.7% + 0.2 × 4.5% = 8.66%.
Discounting five years of growing cash flow and the terminal value at 8.66% gives an enterprise value of about 21,050. Subtract net debt of 3,000 for an equity value of 18,050, and divide by 500 million shares: $36.10 a share. Against a share price of $30, the price is about 17% below this estimate.
But 77% of that value comes from the terminal value: cash flows more than five years away, growing forever. The sensitivity table shows what that means. At a WACC one percentage point higher and terminal growth half a point lower, the value falls to about $28; one point lower with half a point more growth, it rises to about $49. Same business, same cash flow, a range of well over one and a half to one.
Getting the inputs right
- Use unlevered free cash flow: operating cash flow minus capital expenditure, before interest. The model subtracts debt at the end through net debt, so interest must not be taken off first or it is counted twice.
- Keep units consistent. If cash flow is in millions, enter equity, debt, net debt and shares in millions too.
- Terminal growth should be modest. Forever is a long time. Most analysts use 2–3%, around long-run inflation or nominal economic growth; a company cannot outgrow the economy indefinitely.
- Normalise the starting cash flow. One exceptional year, a large asset sale or a working-capital swing can distort everything that is compounded from it.
What a DCF is good for
A DCF rarely tells you what a share is worth to the cent. What it does well is make assumptions explicit. Run it backwards: find the growth rate at which the value equals today’s price, and ask whether that growth is plausible. That reverse question, “what is the market assuming?”, is often more useful than the forward answer. For how a portfolio of positions moves with the market, see the portfolio beta calculator.