What DCF is doing
A DCF values a business by taking expected future free cash flows and discounting them back to present value. Because businesses last beyond the explicit forecast period, DCFs typically add a terminal value that represents cash flows after the forecast horizon.
DCF formula (NPV of cash flows + terminal value)
Enterprise value = sum(FCF_t / (1 + r)^t) + terminal value / (1 + r)^n.
How to calculate DCF (step-by-step)
- Forecast free cash flow (FCF) for each year in the explicit period.
- Choose a discount rate that matches the risk (often WACC as a proxy).
- Discount each year's FCF back to present value.
- Compute terminal value (perpetual growth or exit multiple).
- Discount terminal value back to present value and sum with forecast PVs.
- Adjust enterprise value to equity value using net debt and other claims.
Key inputs and how to choose them
- Free cash flow (FCF): cash available after operating costs and reinvestment (capex/working capital).
- Forecast growth: should fade over time toward a mature level.
- Discount rate: risk-adjusted required return (WACC as a common proxy).
- Terminal growth: conservative long-run growth, lower than discount rate.
Terminal value pitfalls
- Terminal dominates EV: run sensitivity (r, terminal growth).
- Terminal growth >= discount rate: mathematically invalid in perpetuity model.
- Using aggressive terminal growth: implies implausible long-run scale.
Practical checklist
- Build base/optimistic/conservative scenarios.
- Separate unit economics vs macro assumptions (margin, reinvestment).
- Cross-check DCF with multiples as a sanity check (not a substitute).