What a DCF Model Actually Does

A discounted cash flow model answers one question: what is a business worth based on the cash it is expected to generate in the future? The logic is straightforward. A dollar received today is worth more than a dollar received five years from now. The DCF quantifies that difference by projecting future cash flows and discounting them back to the present at a rate that reflects the risk of those cash flows materializing.

Despite its conceptual simplicity, the DCF is one of the most misunderstood models in finance. It is not a crystal ball. It is a framework for translating assumptions about the future into a structured valuation. The quality of the output depends entirely on the quality of the inputs and the rigor of the analysis behind them.

This guide walks through building a DCF from scratch, with emphasis on the practical decisions you face at each step.

Step 1: Gather Historical Financial Data

Start with three to five years of historical financial statements. You need the income statement, balance sheet, and cash flow statement. Pull these from SEC filings (10-K and 10-Q for public companies), the company’s internal accounting system, or a financial data provider.

Organize the historical data with time periods across columns and line items down rows. Key figures to extract include:

  • Revenue
  • Cost of goods sold
  • Operating expenses (broken into major categories)
  • Depreciation and amortization
  • Capital expenditures
  • Changes in working capital (accounts receivable, inventory, accounts payable)
  • Tax rate (effective, not statutory)
  • Debt balance and interest expense

Calculate historical margins, growth rates, and ratios. These become the foundation for your projection assumptions.

Step 2: Project Free Cash Flow

Free cash flow to the firm (FCFF) is the cash available to all capital providers, both debt and equity, after funding operations and investments. The formula is:

FCFF = EBIT x (1 - Tax Rate) + Depreciation & Amortization - Capital Expenditures - Change in Net Working Capital

Revenue Projection

Start with revenue because it drives most other line items. Common approaches include:

  • Growth rate method: Apply an assumed annual growth rate to the prior year’s revenue. Use historical growth as a starting point, adjusted for market conditions and company-specific factors.
  • Bottom-up build: Project units sold multiplied by price per unit, broken out by product line or customer segment. More granular and defensible but requires more assumptions.
  • Market sizing: Estimate the total addressable market, the company’s expected market share, and derive revenue from those figures.

For most DCF models, project five to ten years of explicit cash flows. The projection period should be long enough for the company to reach a steady-state growth rate.

Operating Expenses

Project expenses as a percentage of revenue for variable costs, and as absolute amounts (growing with inflation or specific drivers) for fixed costs. Key assumptions include:

  • Gross margin: Will it expand as the company scales, or compress due to competition?
  • Operating expenses: Are there planned investments that will increase spending in the near term? Is there operating leverage that will improve margins over time?
  • Depreciation: Tie this to the capital expenditure schedule. As a simplification, you can project depreciation as a percentage of gross PP&E.

Capital Expenditures

Project CapEx based on the company’s investment needs. For mature companies, maintenance CapEx (roughly equal to depreciation) may be sufficient. For growing companies, add growth CapEx to fund expansion.

Working Capital Changes

Project accounts receivable, inventory, and accounts payable using days outstanding metrics:

  • Days Sales Outstanding (DSO): Receivables / Revenue x 365
  • Days Inventory Outstanding (DIO): Inventory / COGS x 365
  • Days Payable Outstanding (DPO): Payables / COGS x 365

Assume these metrics remain stable or trend toward industry averages. The change in net working capital from one year to the next feeds into the free cash flow calculation.

Step 3: Calculate the Discount Rate (WACC)

The weighted average cost of capital (WACC) represents the blended return that all capital providers, debt and equity, expect from the business. It is the rate at which you discount future cash flows.

Cost of Equity

Use the Capital Asset Pricing Model (CAPM):

Cost of Equity = Risk-Free Rate + Beta x Equity Risk Premium

  • Risk-free rate: Use the yield on 10-year government bonds. As of early 2026, this is in the range of 4.0 to 4.5 percent for US Treasuries.
  • Beta: Measures the stock’s volatility relative to the market. Use a two-year weekly beta or a five-year monthly beta from a financial data provider. For private companies, use the unlevered beta of comparable public companies and re-lever it for the target’s capital structure.
  • Equity risk premium: The excess return investors expect from equities over the risk-free rate. Most practitioners use a figure between 5 and 7 percent, often referencing Aswath Damodaran’s updated estimates.

Cost of Debt

Use the company’s current borrowing rate, or the yield on its outstanding bonds. Adjust for the tax shield:

After-Tax Cost of Debt = Pre-Tax Cost of Debt x (1 - Tax Rate)

Blending Into WACC

WACC = (Equity / Total Capital) x Cost of Equity + (Debt / Total Capital) x After-Tax Cost of Debt

Use market values for equity (market capitalization) and book values for debt unless market values are readily available.

A typical WACC for a mid-cap company in a stable industry might fall between 8 and 12 percent. If your WACC falls outside this range, double-check your inputs.

Step 4: Calculate Terminal Value

The explicit projection period covers five to ten years, but the company presumably continues operating beyond that. Terminal value captures the value of all cash flows beyond the projection period.

Gordon Growth Method (Perpetuity Growth)

Terminal Value = Final Year FCF x (1 + g) / (WACC - g)

Where g is the long-term perpetual growth rate. This rate should not exceed the long-term GDP growth rate (typically 2 to 3 percent for developed economies). Using a higher rate implies the company will eventually become larger than the entire economy, which is not realistic.

Exit Multiple Method

Terminal Value = Final Year EBITDA x Exit Multiple

The exit multiple is based on current trading multiples of comparable companies. If comparable companies trade at 10x EBITDA today, you might use a similar multiple for the terminal year, adjusted for expected market conditions.

Which Method to Use

Use both and compare the results. If the two methods produce significantly different terminal values, investigate which assumptions are driving the divergence. The terminal value typically represents 60 to 80 percent of the total enterprise value in a DCF, so small changes here have outsized impact.

Step 5: Discount and Sum

Discount each year’s free cash flow and the terminal value back to the present:

Present Value of FCF = FCF / (1 + WACC) ^ n

Where n is the number of years from the present. Sum all the present values to arrive at the enterprise value.

From Enterprise Value to Equity Value

Enterprise value includes the value attributable to all capital providers. To derive the equity value, which is what shareholders own:

Equity Value = Enterprise Value + Cash - Debt - Minority Interests - Preferred Stock

Divide equity value by diluted shares outstanding to arrive at the implied share price.

Step 6: Sensitivity Analysis

A DCF with a single output is not useful. The value of the model is in understanding how the output changes as assumptions vary.

Two-Variable Data Table

Build a data table that shows the implied value across a range of WACC and terminal growth rate assumptions. In Excel, set up the WACC values along the top and growth rates down the side, with the DCF output formula in the corner cell. Use Data > What-If Analysis > Data Table to populate the grid.

A typical table might test WACC from 8 percent to 12 percent in 0.5 percent increments and terminal growth from 1.5 percent to 3.5 percent. This produces a range of valuations rather than a single point estimate.

Scenario Analysis

Create three scenarios: base case, upside, and downside. Each scenario uses a different set of revenue growth, margin, and CapEx assumptions. Present all three valuations side by side so stakeholders understand the range of possible outcomes.

Key Driver Sensitivity

Identify the two or three assumptions that have the largest impact on the output. Typically these are revenue growth, operating margin, and the discount rate. Show how the valuation changes for each one-percentage-point change in these drivers.

Common DCF Mistakes

Overly optimistic growth assumptions. The most common error. Projected growth rates should converge toward the industry average over time, not sustain above-market growth indefinitely.

Inconsistent terminal value assumptions. If your terminal growth rate is 3 percent but your projected CapEx only covers maintenance levels, the company cannot actually grow at 3 percent. Growth requires investment, and the terminal year cash flows should reflect that.

Ignoring working capital. Many DCF models project revenue growth without projecting the corresponding increase in receivables and inventory. This overstates free cash flow.

Using the wrong share count. Use fully diluted shares outstanding, which includes the impact of stock options, warrants, and convertible securities. Using basic shares overstates the per-share value.

Circular reference in debt schedule. Interest expense depends on debt balance, which depends on cash flow, which depends on interest expense. Break this circularity by using beginning-of-period debt for interest calculations or by implementing an iterative solver.

Presenting DCF Results

When presenting a DCF to stakeholders, lead with the range of outcomes rather than a single number. Show the sensitivity analysis prominently. Explain the key assumptions and why you chose them. Acknowledge the limitations: a DCF is a structured way to think about value, not a precise calculation.

The best DCF presentations include a “football field” chart that shows the valuation range from the DCF alongside ranges from comparable company analysis and precedent transactions. This multi-method approach gives stakeholders appropriate context for evaluating the result.