DCF valuation explained: a worked example

A DCF (discounted cash flow) values a company by adding up the cash it will produce in the future, brought back to what it is worth today. The formula fits on one line; the real work is in three assumptions: free cash flow growth, the discount rate and long-term growth. In the example below, the terminal value is 76% of the total, and one point of discount rate moves the value per share by 16 to 22%.

→ Try it with your own assumptions: free DCF calculator, no account needed.

The DCF formula

Enterprise value = FCF₁ / (1 + r) + FCF₂ / (1 + r)² + … + FCFₙ / (1 + r)ⁿ + TV / (1 + r)ⁿ

Terminal value: TV = FCFₙ × (1 + g) / (r − g)

To go from enterprise value to the value of the shares, subtract net debt, then divide by the number of shares. Discounting applies a simple idea: a dollar received in five years is worth less than a dollar today, because it could have been invested in the meantime and because it is uncertain.

A worked example: a fictitious company

Take Company G, a fictitious business (in millions): free cash flow of 100 in the last fiscal year, assumed growth of 8% a year for five years and 2.5% for ever after, a 9% discount rate, net debt of 300 and 100 million shares.

The terminal value at the end of year 5 is 146.9 × 1.025 / (9% − 2.5%) ≈ 2,317, a present value of about 1,505.9.

Figures are rounded. Three quarters of the value (1,505.9 of 1,992.3, or 76%) comes from the terminal value, that is, from what happens after year five. That is the rule rather than the exception: the longer a company grows, the further into the future its value sits.

Sensitivity: what the assumptions change

Company G's value per share by discount rate and perpetual growth, all other assumptions unchanged:

From 13.37 to 22.60: almost 70% apart, with assumptions that are all defensible. A DCF is read as a range, never as an exact price. The DCF calculator shows this table for your own assumptions.

How to choose the assumptions

• Free cash flow growth. Start from history, five to ten years of cash flows, found in annual reports or on our company financials pages, then let it converge to long-term growth. Twenty percent a year for ten years is very rare.
• The discount rate. It pays for risk: the cost of equity (risk-free rate plus an equity risk premium, adjusted by beta) and the after-tax cost of debt, weighted. Aswath Damodaran's data (NYU Stern), updated every year, gives risk premiums and costs of capital by industry. For a large listed company, the rate is often between 7 and 10%.
• Perpetual growth. It cannot stay above the economy's nominal growth, around 2 to 3% for a company in a developed market. Above that, the company would eventually outgrow the economy itself.
• Starting free cash flow. One exceptional year (postponed investment, a one-off receipt) skews the whole calculation; a normal level, averaged over a few years, works better.

The reverse DCF: start from the price

Instead of guessing growth to get a value, you can start from the price and solve for the growth it implies. If Company G's shares traded at 20, it would take free cash flow growth of 11.5% a year for five years to justify that price, all else equal, against 8% in our scenario. The question becomes: has this company ever done that well? That is often easier to judge than "what is it worth?". → Reverse DCF calculator

When the DCF works poorly

• Companies without positive free cash flow (young businesses, heavy investment phases): all the value sits in the terminal value, and the result becomes very uncertain.
• Banks and insurers: debt is their raw material; models based on dividends or return on equity suit them better.
• Highly cyclical companies: free cash flow in a peak or trough year is not a representative starting point.
• A sanity check: comparing the result with simple multiples (P/E, enterprise value to EBITDA) helps spot an unrealistic assumption.

How InvestIQ uses the DCF

In Stock Analysis, the valuation module runs a DCF on the company's free cash flow with its assumptions shown (growth, margin, discount rate, perpetual growth), a sensitivity table and a reverse DCF. The result is one piece of context in the valuation group, which weighs 12% of the score; the details are in the methodology. The public calculators (DCF, reverse DCF, intrinsic value) use the same discounting engine, with your assumptions.

In short

A DCF turns assumptions about a company's future into a number, and makes each of them explicit. That is its strength: you see exactly what you need to believe to get a price. It is also its weakness: three assumptions, above all the terminal value, drive almost the whole result. Read as a range, alongside a reverse DCF and a few multiples, it is the most complete tool for asking what a price assumes.

Educational guidance only, not investment advice.