What Is Discounted Cash Flow (DCF)? A Worked Example, Step by Step
Updated: 4 hours ago
Discounted cash flow (DCF) is a valuation method that estimates what a business is worth today by forecasting the free cash flow it will generate in future years and converting each year's cash into today's money using a discount rate. Add those present values together, adjust for debt, and you have an estimate of intrinsic value. If the share price sits well below that estimate, you may have a margin of safety.
DCF is the most rigorous way to value a business, and also the easiest to fool yourself with. This guide explains the logic, walks through a full worked example year by year, and shows how to keep your assumptions conservative.
Where this fits: DCF is the absolute valuation method behind Criterion 5, Reasonable price. For how it compares with multiples such as P/E and FCF yield, see our hub on what stock valuation is and how to value a stock, part of the Five Criteria.
The Idea Behind DCF: The Time Value of Money
Would you rather have $100 today or $100 in a year? Today, of course. You could invest it and have more than $100 in a year's time. Money today is worth more than the same amount in the future.
That simple idea is the foundation of DCF. To compare future cash with today's share price, you must shrink each future dollar back to its value today. This is called discounting.
Present value = future cash flow divided by (1 + discount rate) raised to the number of years
At a 10% discount rate, $100 received in one year is worth about $91 today. In five years, it is worth about $62. In ten years, just $39. The further away the cash, the less it is worth now.
Warren Buffett defines intrinsic value in Berkshire Hathaway's Owner's Manual as "the discounted value of the cash that can be taken out of a business during its remaining life." A DCF is simply that definition written out in numbers.
The Four Building Blocks of a DCF
Every DCF model rests on four inputs. Get these right, or at least cautious, and the rest is arithmetic.
1. Starting free cash flow
Begin with normalised free cash flow: operating cash flow minus capital expenditures, averaged over several years, with share-based compensation subtracted. Never start from one unusually good year. Our guide to price to free cash flow and FCF yield shows how to normalise it step by step.
2. Growth rate for the forecast period
Forecast free cash flow for the next five to ten years. Base the growth rate on the company's history, the size of its market, the strength of its moat and how much it can reinvest at high returns. Then trim it. Growth usually slows as a company gets bigger.
A common approach is two stages: a higher rate for years 1 to 5, fading to a lower rate for years 6 to 10. Be sceptical of management guidance. Having worked in investor relations, I can tell you that guidance is prepared carefully, but it is still the company's best case, not yours.
3. Discount rate
The discount rate is the annual return you require for owning this business, given its risk and what else you could do with your money. Academics build it from the government bond yield plus a premium for equity risk. Aswath Damodaran of NYU publishes widely used estimates of these inputs.
For individual investors, a simpler approach works well: use a fixed hurdle rate. We suggest 9% to 10% for a solid, established business, and more for anything riskier. It should comfortably exceed what government bonds pay, and you should not lower it just to make a stock look cheap.
4. Terminal value
You cannot forecast cash flows forever, so after the forecast period you estimate a terminal value: the value of all cash flows beyond year 10 in one number. The most common method assumes steady growth forever:
Terminal value = final-year FCF x (1 + terminal growth) divided by (discount rate minus terminal growth)
Terminal growth must be modest. No company can outgrow the economy forever. We use 2% to 2.5%, roughly long-run inflation, and never more than 3%.
The terminal value often makes up more than half of the total value, so it deserves the most caution of all.
Worked Example: A Full DCF for Company D
Company D is a clearly hypothetical business that has already passed Criteria 1 to 4. It earns high returns on capital, has a durable moat and modest debt.
The inputs
Input | Assumption | Why |
Starting FCF | $100 million | Five-year average, after share-based pay |
Growth, years 1 to 5 | 10% a year | Below its 13% historical rate |
Growth, years 6 to 10 | 6% a year | Fading as the business matures |
Discount rate | 9% | Hurdle rate for a solid, established firm |
Terminal growth | 2.5% | Roughly long-run inflation |
Company D also has $200 million of net debt and 50 million shares outstanding. Its shares trade at $48.
Step 1: Forecast and discount ten years of cash flow
Each year's free cash flow is multiplied by a discount factor: 1 divided by 1.09 raised to the number of years.
Year | Free cash flow | Discount factor | Present value |
Year 1 | $110.0m | 0.917 | $100.9m |
Year 2 | $121.0m | 0.842 | $101.8m |
Year 3 | $133.1m | 0.772 | $102.8m |
Year 4 | $146.4m | 0.708 | $103.7m |
Year 5 | $161.1m | 0.650 | $104.7m |
Year 6 | $170.7m | 0.596 | $101.8m |
Year 7 | $181.0m | 0.547 | $99.0m |
Year 8 | $191.8m | 0.502 | $96.3m |
Year 9 | $203.3m | 0.460 | $93.6m |
Year 10 | $215.5m | 0.422 | $91.0m |
Total | $995.6m |
Notice that free cash flow more than doubles over the decade, yet each year's present value barely changes. Growth is working against discounting. That is the time value of money in action.
Step 2: Calculate the terminal value
Year 10 free cash flow is $215.5 million. Grow it by 2.5% and divide by the gap between the discount rate and terminal growth (9% minus 2.5%, or 6.5%).
Terminal value: $215.5m x 1.025 divided by 0.065 = about $3,399 million
Discounted back ten years (x 0.422): about $1,436 million today
Step 3: Add it up and get to a value per share
Component | Value |
Present value of years 1 to 10 | $995.6m |
Present value of terminal value | $1,435.6m |
Enterprise value | $2,431.2m |
Less net debt | minus $200.0m |
Equity value | $2,231.2m |
Intrinsic value per share (50m shares) | $44.62 |
The terminal value is about 59% of the total. That is typical, and it is exactly why the long-run assumptions must be cautious.
Step 4: Apply the margin of safety
Our Criterion 5 default asks for a price at least 25% below a conservative intrinsic value. Take 75% of $44.62 and the buy price is about $33.50.
At $48, Company D trades above our estimate of intrinsic value. It fails the price test today, however good the business. It goes on the watchlist with a target price.
The FCF yield leg tells a similar story. At $48, the market value is $2.4 billion and the FCF yield is about 4.2%. The yield would reach 5% only at $40 a share.
Step 5: Stress-test the answer
A single DCF figure hides how sensitive it is. Change the discount rate and terminal growth rate, and the value per share moves a lot.
Discount rate | Terminal growth 2.0% | Terminal growth 2.5% | Terminal growth 3.0% |
8% | $50.90 | $54.10 | $58.10 |
9% | $42.40 | $44.60 | $47.20 |
10% | $36.10 | $37.70 | $39.40 |
Now test growth. If Company D grows only 5% a year for five years and 3% thereafter, intrinsic value falls to about $31.70. That is close to our $33.50 buy price. This is what the margin of safety is for: if you buy at $33.50 and growth comes in at half your forecast, you are roughly at fair value rather than nursing a permanent loss.
How to Keep Your DCF Conservative
Most DCF errors come from optimism, not arithmetic. A few rules help.
Start from normalised cash, not a peak year. Average five years, or a full cycle for cyclical firms.
Forecast growth below history and below guidance. Great businesses still slow down.
Keep terminal growth at or below inflation. 2% to 2.5% is plenty.
Use a discount rate you would accept for any stock. Do not change it company by company to reach the answer you want.
Subtract net debt, and add back only genuine excess cash.
Run a pessimistic case. If the stock only works in your base case, it does not work.
Round the answer. Your DCF does not say $44.62. It says "somewhere around $40 to $50".
When DCF Works and When It Does Not
DCF works best for stable, cash-generative businesses whose next five to ten years you can reasonably picture. That describes most companies that pass the first four of the Five Criteria.
It struggles with:
Young or unprofitable companies, where cash flows are years away and highly uncertain
Deep cyclicals, where a forecast built on peak-cycle cash will badly overstate value
Turnarounds, where the past is a poor guide to the future
Banks and insurers, whose cash flows do not separate cleanly into operating and financing
When a DCF feels like pure guesswork, that is a signal the business may sit outside your circle of competence.
How We Use DCF in the Five Criteria
Criterion 5 asks whether the price leaves a margin of safety. The house default is that a stock passes if either:
Normalised FCF yield is 5% or more, or
The price is at least 25% below a conservative intrinsic value from a DCF.
In practice, the two tests complement each other. The FCF yield is fast and hard to fudge. The DCF is slower, but it gives credit to a high-quality business that can grow and reinvest at high returns, and it makes every assumption visible.
We use DCF in three ways.
To set a target price for each watchlist company, so you know in advance what you are willing to pay.
To check the market's assumptions. Reverse the model: what growth rate does today's price imply? If it requires 15% growth for a decade, you are being asked to pay for perfection.
To size the margin of safety by showing how much value survives a pessimistic scenario.
For more on why the discount matters, read margin of safety explained.
Common DCF Mistakes
Terminal value overload. Raising terminal growth from 2.5% to 4% can inflate the answer enormously. Keep it modest.
Hockey-stick forecasts. Assuming margins and growth both improve at once, every year, for a decade.
Using earnings instead of free cash flow. A DCF must discount cash, not accounting profit.
Ignoring dilution. Share-based pay and a rising share count reduce value per share.
False precision. Treating a two-decimal answer as fact.
Anchoring on the share price. Building the model with the current price in view nudges your assumptions towards it. Value the business first, then look at the price.
We cover more of these in valuation mistakes beginners make and how to avoid them, and explain the cost of getting price wrong in overpaying for stocks.
Frequently Asked Questions
What discount rate should I use in a DCF? For a solid, established company, 9% to 10% is a sensible hurdle rate for individual investors. Use a higher rate for riskier businesses, and keep your rate consistent across companies so your valuations are comparable.
Why is terminal value so important in a DCF? It captures all the cash flows beyond your forecast period, which is most of a long-lived business's value. It often makes up more than half the total, so small changes in terminal growth move the answer a lot.
Is DCF accurate? It is only as accurate as its assumptions, and the future is uncertain. Treat the output as a range, not a precise number, and always demand a margin of safety of at least 25% below your estimate.
Should I use free cash flow or earnings in a DCF? Free cash flow. It reflects the cash owners can actually take out after capital spending. Earnings include non-cash items and ignore capex, so they can overstate value.
Run your own DCF: our free DCF intrinsic value calculator does the maths for you and shows how much of the value sits in the terminal value.
Your Next Step
Build a simple DCF for one company on your watchlist using the five inputs from the Company D table. Run a pessimistic case, then set a buy price 25% below your base-case value.
For the inputs, start with what free cash flow is. To judge whether today's price is attractive, use when is a stock cheap? A practical framework, or try our investment calculators.
About the author: Cameron Hayes is a senior investor relations and finance professional who has worked in IR at Nasdaq Copenhagen-listed companies including Nilfisk and Maersk Drilling. He holds an MSc from Copenhagen Business School and a BCom from the University of Ottawa, and founded Gingernomics to teach individual investors the Five Criteria framework. More about Gingernomics.
The content on Gingernomics is for educational and informational purposes only and does not constitute financial advice. Always do your own research and consult a licensed financial advisor before making any investment decisions. Past performance is not indicative of future results.
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