How to Build a Discounted Cash Flow (DCF) Model

A Discounted Cash Flow (DCF) model is a financial valuation method used to estimate the intrinsic value of a company or asset. It operates on the principle that an asset’s value today is the present value of its expected future cash flows. Analysts use DCF to determine if an investment is worthwhile by comparing its intrinsic value to its current cost. This technique helps investors assess acquisitions and assists business owners in capital budgeting decisions.

The core idea behind DCF is the time value of money, meaning a dollar today is worth more than a dollar in the future. Future cash flows are therefore “discounted” back to their present value using a rate that reflects risk and timing. This approach provides a fundamental perspective on value, differing from market-based valuations.

Core Components of a DCF Model

Building a DCF model requires understanding its essential components and gathering specific data. These foundational elements include Free Cash Flow (FCF) projections, the Discount Rate, and the Terminal Value. Each plays a distinct role in estimating an asset’s intrinsic value.

Free Cash Flow (FCF)

Free Cash Flow (FCF) represents the cash a company generates from operations after accounting for expenses and reinvestments. It signifies the cash available to all investors, including debt and equity holders.

To project FCF, one forecasts several sub-components, starting with revenue growth. This involves analyzing historical trends, market conditions, and management guidance to establish realistic projections.

Operating expenses, such as cost of goods sold and salaries, are projected, often as a percentage of revenue. Capital expenditures (CapEx), which are investments in long-term assets, are estimated using historical percentages or management plans. Changes in working capital, like accounts receivable and inventory, also influence FCF. Historical financial statements serve as primary data sources for these projections, combined with operational assumptions.

Discount Rate (Weighted Average Cost of Capital – WACC)

The Discount Rate converts future cash flows into their present value, reflecting associated risk. For company valuation, the Weighted Average Cost of Capital (WACC) is used. WACC represents the average return a company expects to pay investors for using their capital, considering both debt and equity.

Calculating WACC requires several inputs. The cost of equity, the return required by equity investors, is often determined using the Capital Asset Pricing Model (CAPM). CAPM considers the risk-free rate, market risk premium, and the company’s beta.

The cost of debt is the interest rate a company pays on its borrowings. Since interest payments are tax-deductible, the cost of debt is adjusted by the company’s effective tax rate. The market values of equity and debt then weight these costs, reflecting their proportion in the capital structure.

Terminal Value

Terminal Value (TV) accounts for the value of all cash flows a business is expected to generate beyond the explicit forecast period. It captures the long-term, ongoing value of the business, assuming it operates indefinitely. TV provides a lump sum representing this perpetual value, as forecasting cash flows for every future year is impractical.

Two common methods calculate Terminal Value. The Perpetuity Growth Model assumes Free Cash Flows grow at a constant, stable rate indefinitely after the forecast period. Key inputs are the final year’s projected FCF, a stable, long-term growth rate, and the WACC. The Exit Multiple Approach estimates TV by applying a multiple (such as Enterprise Value/EBITDA) from comparable companies to a relevant financial metric in the final forecast year.

Structuring and Building the Model

Constructing a DCF model involves organizing data and calculations systematically within a spreadsheet. The process begins with setting up distinct sections for clarity and logical flow, separating assumptions from historical data and projected financials. A typical setup includes areas for historical financial statements, key assumptions, financial projections, WACC calculation, Terminal Value calculation, and valuation output.

Projecting Financials

Projecting future financials is a core part of the model, translating gathered data and assumptions into a Free Cash Flow forecast. This involves creating line items for revenue, cost of goods sold, operating expenses, and depreciation, linking them to growth rates and margin assumptions. Capital expenditures are projected, and changes in net working capital are estimated to determine their cash impact. These calculations lead to the projection of Free Cash Flow for each year of the explicit forecast period.

Calculating WACC

The Weighted Average Cost of Capital (WACC) is integrated by inputting specific data points for each component. The risk-free rate, market risk premium, and beta calculate the cost of equity. The cost of debt is determined from interest rates on borrowings, adjusted for the corporate tax rate. These individual costs are then combined using the market values of equity and debt to arrive at the overall WACC.

Calculating Terminal Value

Once explicit Free Cash Flows and WACC are determined, Terminal Value is calculated using the chosen method. For the perpetuity growth model, the formula involves the final year’s Free Cash Flow, the long-term stable growth rate, and the WACC. For the exit multiple approach, the final year’s relevant financial metric, such as EBITDA, is multiplied by an appropriate market multiple.

Discounting Cash Flows

The final step involves discounting projected cash flows and the Terminal Value back to the present. Each year’s projected Free Cash Flow is discounted using the WACC, and the calculated Terminal Value is also discounted to its present value. The sum of these present values yields the Enterprise Value. To arrive at the Equity Value, net debt and any non-operating assets are adjusted from the Enterprise Value. Dividing the Equity Value by the number of diluted shares outstanding provides the intrinsic value per share.

Interpreting Model Outputs

After constructing the DCF model and deriving a valuation, interpreting the results involves more than a single number. The final intrinsic value provides an estimate of what the company or asset is worth today based on its future cash-generating ability. This value can then be compared to the current market price to assess if the asset appears undervalued or overvalued.

Sensitivity analysis helps understand the impact of varying assumptions on the final valuation. This technique involves systematically changing key inputs, such as revenue growth rates, the discount rate (WACC), or the terminal growth rate, to observe how these changes affect the intrinsic value. Sensitivity tables display a range of possible valuations under different scenarios.

The DCF valuation is employed in various financial decision-making contexts. It helps investors determine if an acquisition or stock purchase aligns with their value expectations. It is also valuable in mergers and acquisitions (M&A) to assess a target company’s worth. For internal corporate finance, DCF supports capital budgeting and strategic planning. While comprehensive, a DCF model is generally used with other valuation methods for a holistic view.