How a discounted cash flow valuation works

A discounted cash flow (DCF) model rests on one idea: a business is worth the cash it can hand its owners over time, discounted back to what that future cash is worth today. "Discounted" matters because a dollar arriving in year eight is worth less than a dollar in hand now — it has to be adjusted downward for the time value of money and for the risk that it doesn't show up at all. The standard version of this, and the one we use, is Aswath Damodaran's free-cash-flow-to-the-firm approach.

1. Start with revenue and a growth path

The model starts with trailing revenue, then projects a growth rate forward — typically derived from how much the company has historically reinvested and the return it's earned on that reinvestment, rather than a guess. High growth rarely lasts forever, so the rate is faded down over the forecast toward a stable, long-run rate (we use the risk-free rate, on the reasoning that no company can out-grow the economy indefinitely).

2. Apply a margin to get operating profit

Revenue isn't profit. The model applies an operating margin — today's margin moving toward a target informed by the company's own history and its industry peers — to turn projected revenue into projected operating income.

3. Subtract reinvestment to get free cash flow

Growing a business costs money: new plant, equipment, working capital. The model estimates how much new capital each dollar of additional revenue requires (a "sales-to-capital" ratio) and subtracts that reinvestment from after-tax operating profit. What's left is free cash flow to the firm — the cash actually available to lenders and shareholders.

4. Discount it back at the cost of capital

Each year's projected free cash flow is discounted back to today using the weighted average cost of capital (WACC) — a blended rate reflecting both the return equity investors require and the interest rate on the company's debt, weighted by how much of each the company actually uses.

5. Add a terminal value

No model forecasts forever. After the explicit forecast window, the business is assumed to settle into a steady state, growing at a stable rate with new investment earning only its cost of capital — the idea being that outsized returns attract competition until they're competed away. That steady state is capitalized into a single terminal value using the Gordon growth formula, which usually accounts for the majority of a DCF's total value — a detail worth checking on any valuation you're handed, since it means the model is mostly a bet on the distant future, not the next few years.

6. Subtract net debt, divide by shares

Discounting every year's cash flow and the terminal value gives the enterprise value — what the whole business, debt and equity together, is worth. Subtract net debt (and anything else that isn't common equity, like preferred stock or minority interests) to get equity value, then divide by shares outstanding to get a value per share.