Overview
What this model is and what it produces
The Discounted Cash Flow (DCF) model estimates intrinsic enterprise value by projecting future free cash flows and discounting them to present value using the weighted average cost of capital (WACC). Terminal value captures value beyond the explicit forecast period. This is the foundational valuation methodology used across investment banking, private equity, and corporate finance.
Purpose
Determine the intrinsic value of a business independent of market sentiment, supporting investment decisions, M&A pricing, and strategic planning.
Key Outputs
- Enterprise Value (EV)
- Implied Equity Value
- Implied Share Price
- Sensitivity Tables
- Key Value Driver Analysis
When to Use
- Valuing a business with predictable, positive cash flows
- M&A transactions requiring intrinsic value assessment
- Strategic planning and capital allocation decisions
- Comparing intrinsic value to market value for investment decisions
- Board presentations requiring defensible valuation methodology
Why This Model Exists
The problem it solves and where it fits
Problem Solved
Market prices fluctuate based on sentiment, supply/demand, and short-term factors. The DCF model solves for fundamental value by focusing on what a business actually generates—cash flows—and what those are worth today given the time value of money and risk.
Why Not Simpler Approaches?
Simpler approaches like revenue multiples or P/E ratios rely on comparable companies and market conditions. They cannot capture unique growth profiles, capital structures, or cash flow dynamics. DCF forces explicit assumptions about value drivers, making the analysis transparent and defensible.
Preferred When
- Cash flows are relatively predictable (mature businesses, contracted revenues)
- Comparable companies are unavailable or poorly matched
- The analysis requires explicit assumption documentation
- Long-term value creation matters more than near-term multiples
- Capital structure differs significantly from comparables
DCF is the primary methodology taught in investment banking training programs (e.g., Wall Street Prep, Training the Street) and is required in fairness opinions and transaction documentation.
How the Model Works
Structure and flow
Revenue and expense projections drive operating income (EBIT), which is adjusted for taxes, non-cash charges, and reinvestment requirements to calculate Free Cash Flow to Firm (FCFF). These cash flows are discounted using WACC. Terminal value—calculated via perpetuity growth or exit multiple—captures value beyond the forecast period. The sum of discounted cash flows and terminal value yields Enterprise Value.
Model Sections
Assumptions
Document all input assumptions (growth rates, margins, WACC components)
Revenue Build
Project revenues by segment, geography, or driver
Income Statement
Forecast operating expenses, EBITDA, and EBIT
Working Capital
Model changes in NWC to derive cash impact
Capital Expenditures
Forecast maintenance and growth CapEx
Free Cash Flow
Calculate FCFF from EBIT, taxes, D&A, NWC, CapEx
WACC Calculation
Compute discount rate from cost of equity and debt
Terminal Value
Calculate value beyond forecast using perpetuity or exit multiple
Valuation Summary
Present EV, bridge to equity value, implied share price
Sensitivity Analysis
Test value under different WACC and growth assumptions
- Revenue assumptions flow through to EBITDA and EBIT
- Margin assumptions drive operating cash flow
- CapEx and NWC assumptions determine reinvestment
- WACC calculation requires capital structure assumptions
- Terminal value is highly sensitive to perpetuity growth rate
Key Drivers & Variables
What matters most for value
Primary Drivers
Weighted Average Cost of Capital (WACC)
very-highA 50bps change in WACC can shift value by 10-20%. WACC encapsulates the return required by all capital providers.
View variable detailsTerminal Value / Perpetuity Growth
very-highTerminal value often represents 60-80% of total value. Small changes in perpetuity growth rate dramatically affect valuation.
View variable detailsRevenue Growth Rate
highTop-line growth is the primary driver of cash flow scale. Assumptions must be defensible against market data.
View variable detailsEBITDA Margin
highOperating leverage determines how much revenue converts to cash. Margin expansion/contraction significantly impacts value.
View variable detailsKey Assumptions Required
- Explicit forecast period (typically 5-10 years)
- Tax rate and tax shield value
- Steady state assumptions for terminal value
- Target capital structure vs current structure
- Mid-year vs end-of-year discounting convention
Best Practices & Common Pitfalls
How to do it well
Best Practices
Use mid-year discounting
Cash flows are received throughout the year, not at year-end. Mid-year convention better reflects reality.
Reconcile terminal growth to GDP
No company grows faster than the economy indefinitely. Terminal growth should not exceed long-term nominal GDP (2-3%).
Sanity check with multiples
Implied exit multiple from terminal value should be reasonable compared to current trading multiples.
Build in convergence
Margins, growth, and reinvestment should converge to sustainable levels by end of forecast period.
Document all assumptions
Every input should have a source or rationale. Models without documentation lose credibility.
Common Pitfalls
Terminal value dominance
When terminal value exceeds 80% of total value, the model is essentially a perpetuity calculation. Extend forecast period or revisit growth assumptions.
Inconsistent WACC
Using book value weights instead of market value, or mismatching cost of equity derivation with actual capital structure.
Ignoring reinvestment requirements
Assuming growth without corresponding CapEx and working capital investment is economically unrealistic.
Extrapolating peak performance
Assuming current-year margins or growth rates continue indefinitely. Mean reversion is typical.
Pro Tips
- Build a reverse DCF to see what growth is implied by current market price
- Use football field charts to compare DCF value with trading and transaction multiples
- Present ranges (25th-75th percentile) rather than point estimates
- Separately value high-growth and mature business segments
Example Use Case
Applied thinking
A private equity associate is evaluating a potential acquisition of a mid-market industrial distributor with stable cash flows and 15% EBITDA margins.
Role: PE Associate at a middle-market buyout fund
Application
The associate builds a 7-year DCF model using management projections, adjusts for normalized CapEx, and calculates WACC based on the target capital structure post-acquisition. Sensitivity analysis tests valuation under different margin expansion and exit multiple scenarios.
Insight Generated
DCF analysis reveals intrinsic value of $450M at base case, supporting a maximum bid of $400M at target returns. Terminal value comprises 65% of value—the associate extends the forecast period to 10 years to reduce terminal dependence and improve confidence.
Illustrative Data
Revenue Year 1
$200M
EBITDA Margin
15%
WACC
9.5%
Terminal Growth
2.5%
Enterprise Value
$450M
Terminal Value %
65%
When NOT to Use This Model
Know the limitations
Early-stage startups with negative cash flows
DCF requires positive cash flows or a clear path to profitability. For pre-revenue or cash-burning companies, VC valuation methods are more appropriate.
Highly cyclical businesses at peak earnings
Extrapolating peak-cycle performance leads to overvaluation. Normalized earnings or through-cycle analysis is required.
Financial institutions
Banks and insurers require specialized models (dividend discount, residual income) due to regulatory capital and different cash flow definitions.
Companies undergoing restructuring
Turnaround situations have highly uncertain cash flows. Option-based or scenario-weighted approaches may be more appropriate.
Consider These Alternatives
When company has distinct high-growth and mature phases
When capital structure is changing significantly over forecast period
When market-based validation is primary objective and good comparables exist
For early-stage companies with negative near-term cash flows
Critical Assumptions That Must Hold
- Company will continue as going concern
- Cash flows are reasonably predictable
- Discount rate appropriately reflects risk
- Terminal value assumptions are sustainable indefinitely
- No significant events (regulatory, competitive) that invalidate projections
Related Models
Explore connected frameworks
Two-Stage DCF
VariantExplicitly models high-growth and steady-state periods with different assumptions
Coming SoonThree-Stage DCF
VariantAdds transition period between growth and maturity
Coming SoonAdjusted Present Value
AlternativeSeparates operating value from financing effects; preferred when leverage changes
Coming SoonFree Cash Flow to Equity
ComplementaryValues equity directly; useful when target capital structure is stable
Coming SoonComparable Company Analysis
ComplementaryMarket-based valuation for triangulation and sanity checking DCF output
LBO Model
ComplementaryDetermines value from a financial buyer perspective based on target returns
Ready to build your Standard DCF Model?
Sign in to access model templates and Finny assistance.