Discounted cash flow analysis

A discounted cash flow (DCF) analysis values a business from the cash it is expected to produce. The idea underneath it is the present value rule: the value of any asset is the present value of the cash flows expected from it, each one discounted at a rate that reflects how risky it is[1Source 1Aswath Damodaran, Investment Valuation: Tools and Techniques for Determining the Value of Any Asset, 3rd ed. (Wiley, 2012), ch. 2, “Basis for Discounted Cash Flow Valuation” and “Equity Valuation and Firm Valuation”.]. Applied to a company, that means projecting the cash the business will throw off for some years, adding a lump for everything after that, and discounting the whole stream back to today[2Source 2Joshua Rosenbaum and Joshua Pearl, Investment Banking: Valuation, LBOs, M&A, and IPOs, 3rd ed. (Wiley, 2020), ch. 3: the method and its five steps, pp. 115–119; WACC, p. 131; the perpetuity growth method, pp. 139–140; present value, p. 141.]. Bankers, corporate finance staff, professors and investors all use it, and the number it produces is called the company’s intrinsic value, to distinguish it from the market value that trading happens to give the company on a particular day[2Source 2Joshua Rosenbaum and Joshua Pearl, Investment Banking: Valuation, LBOs, M&A, and IPOs, 3rd ed. (Wiley, 2020), ch. 3: the method and its five steps, pp. 115–119; WACC, p. 131; the perpetuity growth method, pp. 139–140; present value, p. 141.].

The five steps

One standard text lays the method out in five steps: study the target and find what drives its performance; project its free cash flow; calculate the weighted average cost of capital; determine the terminal value; and calculate the present value and the valuation[2Source 2Joshua Rosenbaum and Joshua Pearl, Investment Banking: Valuation, LBOs, M&A, and IPOs, 3rd ed. (Wiley, 2020), ch. 3: the method and its five steps, pp. 115–119; WACC, p. 131; the perpetuity growth method, pp. 139–140; present value, p. 141.]. The steps are worth taking one at a time, because each is a place where the answer is decided.

Step one: study the business

The projections are only as good as the understanding behind them. For a public company the reading list is the annual and quarterly filings, earnings-call transcripts and investor presentations; for a private one it is what management supplies or, failing that, trade press and the filings of public competitors, customers and suppliers[2Source 2Joshua Rosenbaum and Joshua Pearl, Investment Banking: Valuation, LBOs, M&A, and IPOs, 3rd ed. (Wiley, 2020), ch. 3: the method and its five steps, pp. 115–119; WACC, p. 131; the perpetuity growth method, pp. 139–140; present value, p. 141.]. The point is to find the few things that drive sales growth, margins and cash generation, so that the projections can be defended.

Step two: project free cash flow

The cash flow a DCF discounts is unlevered free cash flow: the cash a company generates after paying its cash operating expenses and taxes and after funding capital expenditure and working capital, but before paying any interest[2Source 2Joshua Rosenbaum and Joshua Pearl, Investment Banking: Valuation, LBOs, M&A, and IPOs, 3rd ed. (Wiley, 2020), ch. 3: the method and its five steps, pp. 115–119; WACC, p. 131; the perpetuity growth method, pp. 139–140; present value, p. 141.]. “Unlevered” means the financing has been left out on purpose, so that the number describes the business, not its balance sheet. It is projected for about five years in most cases, long enough to cover a business cycle, to a point where the company’s performance is judged to have reached a steady state[2Source 2Joshua Rosenbaum and Joshua Pearl, Investment Banking: Valuation, LBOs, M&A, and IPOs, 3rd ed. (Wiley, 2020), ch. 3: the method and its five steps, pp. 115–119; WACC, p. 131; the perpetuity growth method, pp. 139–140; present value, p. 141.].

Step three: the discount rate

Because unlevered cash flow belongs to everyone who has funded the company, lenders and shareholders alike, it is discounted at a rate that blends what both require: the weighted average cost of capital, or WACC[3Source 3Tim Koller, Marc Goedhart and David Wessels, Valuation: Measuring and Managing the Value of Companies, 7th ed. (Wiley, 2020), ch. 10, “Enterprise Discounted Cash Flow Model”, “Valuing Operations” and “Discounting Free Cash Flow at the Weighted Average Cost of Capital”.]. It is the weighted average of the required return on the company’s debt and equity, and so it depends on the company’s capital structure[2Source 2Joshua Rosenbaum and Joshua Pearl, Investment Banking: Valuation, LBOs, M&A, and IPOs, 3rd ed. (Wiley, 2020), ch. 3: the method and its five steps, pp. 115–119; WACC, p. 131; the perpetuity growth method, pp. 139–140; present value, p. 141.]. In the formula, the after-tax cost of debt is weighted by the share of debt in the company’s capital and the cost of equity by the share of equity[3Source 3Tim Koller, Marc Goedhart and David Wessels, Valuation: Measuring and Managing the Value of Companies, 7th ed. (Wiley, 2020), ch. 10, “Enterprise Discounted Cash Flow Model”, “Valuing Operations” and “Discounting Free Cash Flow at the Weighted Average Cost of Capital”.]. The cost of debt is taken after tax because interest is deductible and that tax saving has been left out of the cash flows; moving it into the discount rate is what lets the cash flows describe operations alone[3Source 3Tim Koller, Marc Goedhart and David Wessels, Valuation: Measuring and Managing the Value of Companies, 7th ed. (Wiley, 2020), ch. 10, “Enterprise Discounted Cash Flow Model”, “Valuing Operations” and “Discounting Free Cash Flow at the Weighted Average Cost of Capital”.]. Using one WACC for every year quietly assumes the company keeps its mix of debt and equity constant; when the mix is expected to change, other methods exist[3Source 3Tim Koller, Marc Goedhart and David Wessels, Valuation: Measuring and Managing the Value of Companies, 7th ed. (Wiley, 2020), ch. 10, “Enterprise Discounted Cash Flow Model”, “Valuing Operations” and “Discounting Free Cash Flow at the Weighted Average Cost of Capital”.].

Step four: the terminal value

Nobody projects cash flows forever, so a terminal value stands for everything after the projection period. It is usually a large share of the total, which is why the final projected year has to look like a normal year rather than a peak or a trough[2Source 2Joshua Rosenbaum and Joshua Pearl, Investment Banking: Valuation, LBOs, M&A, and IPOs, 3rd ed. (Wiley, 2020), ch. 3: the method and its five steps, pp. 115–119; WACC, p. 131; the perpetuity growth method, pp. 139–140; present value, p. 141.]. There are two accepted ways to compute it. The exit multiple method applies a multiple, typically of EBITDA, to the final year’s figure, as if the business were sold then. The perpetuity growth method treats the final year’s cash flow as a perpetuity growing at a constant rate[2Source 2Joshua Rosenbaum and Joshua Pearl, Investment Banking: Valuation, LBOs, M&A, and IPOs, 3rd ed. (Wiley, 2020), ch. 3: the method and its five steps, pp. 115–119; WACC, p. 131; the perpetuity growth method, pp. 139–140; present value, p. 141.]:

terminal value = FCF × (1 + g) ÷ (r − g)

where FCF is the final year’s free cash flow, g the long-run growth rate and r the WACC[2Source 2Joshua Rosenbaum and Joshua Pearl, Investment Banking: Valuation, LBOs, M&A, and IPOs, 3rd ed. (Wiley, 2020), ch. 3: the method and its five steps, pp. 115–119; WACC, p. 131; the perpetuity growth method, pp. 139–140; present value, p. 141.]. The growth rate is typically chosen near the company’s long-term industry growth, generally 2 to 4 percent, in the region of nominal GDP growth[2Source 2Joshua Rosenbaum and Joshua Pearl, Investment Banking: Valuation, LBOs, M&A, and IPOs, 3rd ed. (Wiley, 2020), ch. 3: the method and its five steps, pp. 115–119; WACC, p. 131; the perpetuity growth method, pp. 139–140; present value, p. 141.]; another author reports the usual suggestions, GDP growth or the rate of inflation, and reminds the reader that the rate has to hold for many years, whatever the current environment[4Source 4Paul Pignataro, Financial Modeling and Valuation: A Practical Guide to Investment Banking and Private Equity, 2nd ed. (Wiley, 2022), “Discounted Cash Flow Analysis” and “Perpetuity Method”.]. It is good practice to run both methods and compare, since a large gap between them says something about either the projections or the market[4Source 4Paul Pignataro, Financial Modeling and Valuation: A Practical Guide to Investment Banking and Private Equity, 2nd ed. (Wiley, 2022), “Discounted Cash Flow Analysis” and “Perpetuity Method”.].

Step five: discount and sum

Each year’s cash flow and the terminal value are multiplied by a discount factor, the present value of one dollar received at that date. At a 10 percent discount rate, a dollar a year away is worth about 0.91 today[2Source 2Joshua Rosenbaum and Joshua Pearl, Investment Banking: Valuation, LBOs, M&A, and IPOs, 3rd ed. (Wiley, 2020), ch. 3: the method and its five steps, pp. 115–119; WACC, p. 131; the perpetuity growth method, pp. 139–140; present value, p. 141.]. The discounted cash flows and the discounted terminal value add up to an enterprise value, the value of the whole business. Subtracting debt and the other claims that rank ahead of the shares gives an equity value[3Source 3Tim Koller, Marc Goedhart and David Wessels, Valuation: Measuring and Managing the Value of Companies, 7th ed. (Wiley, 2020), ch. 10, “Enterprise Discounted Cash Flow Model”, “Valuing Operations” and “Discounting Free Cash Flow at the Weighted Average Cost of Capital”.], and dividing by the shares gives a value per share[2Source 2Joshua Rosenbaum and Joshua Pearl, Investment Banking: Valuation, LBOs, M&A, and IPOs, 3rd ed. (Wiley, 2020), ch. 3: the method and its five steps, pp. 115–119; WACC, p. 131; the perpetuity growth method, pp. 139–140; present value, p. 141.].

Why it is shown as a range

The projections themselves have the greatest effect on the answer[2Source 2Joshua Rosenbaum and Joshua Pearl, Investment Banking: Valuation, LBOs, M&A, and IPOs, 3rd ed. (Wiley, 2020), ch. 3: the method and its five steps, pp. 115–119; WACC, p. 131; the perpetuity growth method, pp. 139–140; present value, p. 141.]; after them, two assumptions with a large effect are the discount rate and the terminal value, and small changes in either move the result a lot. So the output of a DCF is a range, produced by varying the key inputs, and not a single number[2Source 2Joshua Rosenbaum and Joshua Pearl, Investment Banking: Valuation, LBOs, M&A, and IPOs, 3rd ed. (Wiley, 2020), ch. 3: the method and its five steps, pp. 115–119; WACC, p. 131; the perpetuity growth method, pp. 139–140; present value, p. 141.]. That is also the method’s character in one sentence: its strength is that defensible assumptions shield the valuation from a distorted market, and its weakness is that it is only as strong as those assumptions[2Source 2Joshua Rosenbaum and Joshua Pearl, Investment Banking: Valuation, LBOs, M&A, and IPOs, 3rd ed. (Wiley, 2020), ch. 3: the method and its five steps, pp. 115–119; WACC, p. 131; the perpetuity growth method, pp. 139–140; present value, p. 141.]. One practitioner’s text calls the DCF the most “technical” of the three main valuation methods, because it rests on the company’s cash flows rather than on market data, and lists its three weak points in the same breath: the terminal value is a very large share of the total, the projections may be wrong, and the discount rate is hard to estimate[4Source 4Paul Pignataro, Financial Modeling and Valuation: A Practical Guide to Investment Banking and Private Equity, 2nd ed. (Wiley, 2022), “Discounted Cash Flow Analysis” and “Perpetuity Method”.]. The usual remedy is to set the range beside those from comparable companies analysisComparable companies analysisComparable companies analysis values a business from the multiples similar public companies trade at: choosing peers, spreading the numbers, picking a range.Terms and methods · revised 28 September 2026 · 1,109 words · 3 sources · 5 min and precedent transactions and see whether they agree[2Source 2Joshua Rosenbaum and Joshua Pearl, Investment Banking: Valuation, LBOs, M&A, and IPOs, 3rd ed. (Wiley, 2020), ch. 3: the method and its five steps, pp. 115–119; WACC, p. 131; the perpetuity growth method, pp. 139–140; present value, p. 141.].

Two paths, one answer

There is a second way to run the same logic. Instead of discounting the cash available to everyone at the WACC, one can discount the cash left for shareholders alone, after interest and debt payments, at the cost of equity, and arrive at equity value directly[1Source 1Aswath Damodaran, Investment Valuation: Tools and Techniques for Determining the Value of Any Asset, 3rd ed. (Wiley, 2012), ch. 2, “Basis for Discounted Cash Flow Valuation” and “Equity Valuation and Firm Valuation”.]. The enterprise route is the one the banking texts teach[2Source 2Joshua Rosenbaum and Joshua Pearl, Investment Banking: Valuation, LBOs, M&A, and IPOs, 3rd ed. (Wiley, 2020), ch. 3: the method and its five steps, pp. 115–119; WACC, p. 131; the perpetuity growth method, pp. 139–140; present value, p. 141.], because it values the business independently of how it happens to be financed; done consistently, the two paths meet at the same number[3Source 3Tim Koller, Marc Goedhart and David Wessels, Valuation: Measuring and Managing the Value of Companies, 7th ed. (Wiley, 2020), ch. 10, “Enterprise Discounted Cash Flow Model”, “Valuing Operations” and “Discounting Free Cash Flow at the Weighted Average Cost of Capital”.]. The enterprise value and equity valueEnterprise value and equity valueEquity value is what the shares are worth; enterprise value is what the whole business is worth to all who fund it. How they link, and why cash is subtracted.Terms and methods · revised 28 September 2026 · 921 words · 4 sources · 5 min article explains the bridge between the two.

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  author       = {{xlsx.dev}},
  title        = {{Discounted cash flow analysis}},
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