If you want to know the true value of a business or investment, a Discounted Cash Flow (DCF) model is one of the most powerful tools in finance. It helps you estimate what a company is worth today based on its future expected cash flows.
Here’s a simple guide to building your own DCF model:
🔹 Step 1: Forecast Free Cash Flows (FCF)
The foundation of a DCF is free cash flow – the money a company generates after paying operating expenses and investing in assets.
Formula:
FCF = Operating Cash Flow – Capital Expenditures
👉 Typically, analysts forecast FCF for 5–10 years using revenue growth, operating margins, and investment assumptions.
🔹 Step 2: Estimate the Terminal Value (TV)
Since companies don’t stop after your forecast period, you need to estimate value beyond it. Two methods are common:
- Perpetuity Growth Method
TV = \frac{FCF_{n+1}}{(WACC – g)}
- Exit Multiple Method
Apply a valuation multiple (like EV/EBITDA) to the final forecast year.
🔹 Step 3: Select the Discount Rate
(WACC)
DCF works by “discounting” future cash flows to today’s value. The rate you use is the Weighted Average Cost of Capital (WACC), which blends:
Cost of Equity (using CAPM formula)
After-tax Cost of Debt
This represents the return expected by investors.
🔹 Step 4: Discount the Cash Flows
Now bring everything back to present
value using:
DCF = \sum_{t=1}^{n} \frac{FCF_t}{(1+WACC)^t} + \frac{TV}{(1+WACC)^n}
Each year’s FCF and the terminal value are discounted back to today.
🔹 Step 5: Calculate Enterprise & Equity Value
Enterprise Value (EV) = Sum of discounted FCF + discounted terminal value
Subtract Net Debt (Debt – Cash)
What’s left is Equity Value
Divide by shares outstanding = Intrinsic Value per Share
✅ Example (Simplified)
FCFs for 5 years: $10M, $12M, $15M, $18M, $20M
WACC = 10%
Terminal growth = 3%
When discounted and added, this gives the company’s estimated Enterprise Value.
✨ Final Thoughts
A DCF model may seem complex at first, but it’s simply a way of asking: “What are future cash flows worth in today’s money?” With practice, it becomes one of the most reliable valuation tools for investors, entrepreneurs, and finance professionals.
