DCF valuation explained: a step-by-step guide

A discounted cash flow (DCF) valuation estimates what a business is worth today from the cash it is expected to generate in the future. It rests on one idea from the time value of money: a riyal or dollar received later is worth less than one received now, so future cash must be discounted back to today at a rate that reflects its risk.

The five steps of a DCF

1. Forecast unlevered free cash flow for a period (usually 5–10 years).
2. Estimate the discount rate — the weighted average cost of capital (WACC).
3. Estimate a terminal value for all cash flows after the forecast.
4. Discount the forecast cash flows and the terminal value to today and add them: this is enterprise value.
5. Bridge to equity value by subtracting net debt, then divide by diluted shares for a value per share.

Step 1: unlevered free cash flow

Unlevered free cash flow is the cash a business generates for all its investors — lenders and shareholders — after the investment needed to sustain it:

FCF = EBIT × (1 − tax rate) + depreciation & amortization − capital expenditure − increase in net working capital

Start with operating profit (EBIT), tax it as if the company had no debt, add back non-cash charges, then subtract investment in fixed assets and in working capital. Financing costs (interest) are left out on purpose: they are reflected in the discount rate instead.

A good forecast is driven by a few assumptions — revenue growth, margins, and reinvestment as a percentage of revenue — kept in one clearly labelled block, so the model updates when you change them.

Step 2: the discount rate (WACC)

Because unlevered FCF belongs to both lenders and shareholders, it is discounted at the weighted average cost of capital:

WACC = E/(D+E) × cost of equity + D/(D+E) × cost of debt × (1 − tax rate)

The cost of equity is commonly estimated with CAPM: risk-free rate + beta × equity risk premium. Use market values for the weights where possible. Every input is an estimate, which is why a single-point DCF should always be accompanied by sensitivity analysis.

Step 3: terminal value

A forecast covers a few years; the business may last decades. The terminal value captures everything after the forecast. The Gordon growth method assumes cash flows grow at a constant rate g forever:

Terminal value = FCF in the final year × (1 + g) ÷ (WACC − g)

Two rules keep it sensible: g must be below WACC, and in the long run it shouldn't exceed the growth of the economy. The alternative exit multiple method values the business at a multiple of final-year EBITDA; analysts often compute both and compare.

Step 4: enterprise value

Discount each forecast year's FCF by 1 ÷ (1 + WACC)ᵗ and discount the terminal value with the final forecast year's factor — it is a value at the end of that year. Their sum is enterprise value (EV): the value of the operating business to all capital providers.

It's normal for the terminal value to be a large share of EV — often more than half. That isn't an error, but it means the result depends heavily on the terminal assumptions.

Step 5: from enterprise value to value per share

Shareholders own what is left after lenders are repaid:

Equity value = enterprise value − net debt, where net debt = debt − cash.

Divide by diluted shares outstanding for a value per share. A common mistake is adding net debt instead of subtracting it, or dividing enterprise value (rather than equity value) by the share count.

Checks every analyst runs

• Sensitivity table: value across a range of WACC and growth assumptions.
• Terminal value share: how much of EV comes from beyond the forecast?
• Implied exit multiple: does the Gordon terminal value imply a reasonable EV/EBITDA?
• Consistency: are growth, margins and reinvestment consistent with each other? High growth needs investment.

Practise it

Reading about a DCF is easy; building one is where understanding comes from. The Company Valuation track walks through each component in a live worksheet and checks your formulas — including whether your model actually updates when the assumptions change.