What is a DCF?
A discounted cash flow (DCF) values a business as the sum of the cash it is expected to generate in the future, each year discounted back to today at a rate that reflects the risk and time value of that money. It is the most fundamentals-driven of the valuation methods: it asks what the company is intrinsically worth, independent of what comparable companies happen to trade at.
The logic is that a dollar arriving in five years is worth less than a dollar today, and a riskier dollar is worth less than a safer one. The discount rate captures both. Project the cash, discount it, add it up — the total is the intrinsic value.
A DCF is only as good as its inputs. Small changes in the growth rate, the discount rate, or the terminal assumptions swing the answer dramatically, which is why a DCF is always run as a range, never a single number.
How a DCF is built
An unlevered DCF — the standard for valuing the whole enterprise — follows a set sequence.
- Project free cash flow for an explicit forecast period, usually five to ten years. Unlevered free cash flow is the cash the operations throw off before financing.
- Choose a discount rate. For an enterprise DCF this is the weighted average cost of capital (WACC), blending the cost of equity and after-tax cost of debt.
- Discount each year's cash flow to present value using that rate.
- Add a terminal value to capture the cash flows beyond the forecast horizon, then discount it back as well.
- Sum the pieces to get enterprise value, then bridge to equity value by netting debt and other claims.
The terminal value typically accounts for the majority of the total — which is precisely why its assumptions deserve the most scrutiny.
What a DCF is good and bad at
A DCF shines when cash flows are reasonably predictable — stable, cash-generative businesses where a forecast can be defended. It forces an analyst to articulate exactly what they believe about growth, margins, and capital intensity, and it values a company on its own merits rather than the mood of the market.
It struggles with early-stage, cyclical, or rapidly changing businesses, where the forecast is largely guesswork and the terminal value dominates the answer. The discipline is to use the DCF as one bar on the valuation summary — a check on the multiples-based methods — rather than a precise verdict on its own.