Most valuation metrics like P/E and EV/EBITDA compare a stock's price to current or recent financial performance. Discounted cash flow analysis takes a fundamentally different approach: it estimates what a business is worth today based on all the cash it will generate in the future.
DCF is the foundation of intrinsic value investing and the method most commonly used by professional analysts to determine whether a stock is overvalued or undervalued.
What Is DCF Analysis
DCF analysis calculates the present value of a company's expected future cash flows. The core principle is the time value of money: a dollar received today is worth more than a dollar received five years from now because today's dollar can be invested.
By projecting future free cash flow and discounting it back to present value, investors arrive at an estimate of intrinsic value. If intrinsic value exceeds the current stock price, the stock may be undervalued.
Unlike relative metrics that compare one stock to another, DCF provides an absolute estimate of worth independent of market sentiment.
Building a DCF Model
A DCF model has three main components: projected free cash flows, a discount rate, and a terminal value.
Projecting free cash flows
Free cash flow (FCF) is the cash remaining after operating expenses and capital expenditures. It represents cash available to all capital providers.
Most models project FCF for five to ten years, starting from the company's current earnings base and estimating growth based on industry trends, competitive position, and margin trajectories. Small changes in growth or margin assumptions can produce dramatically different valuations.
Discounting to present value
Each year's projected cash flow is divided by a discount factor that reflects the time value of money and the risk of the investment. Cash flows further in the future are discounted more heavily because they are less certain.
The formula for present value of a single cash flow is: PV = FCF / (1 + r)^n, where r is the discount rate and n is the number of years.
Discount Rate and WACC
The discount rate is the required return that compensates investors for risk. For company-level DCF models, the weighted average cost of capital (WACC) is the standard choice.
WACC blends the cost of equity and cost of debt, weighted by their proportion in the capital structure. The cost of equity is typically estimated using models like the Capital Asset Pricing Model, which factors in the risk-free rate, equity risk premium, and the stock's beta.
Discount rate sensitivity is significant. A one-percentage-point change in WACC can shift valuation by 10 to 20 percent. Higher rates reduce present values; lower rates increase them. This is why interest rate environments directly influence valuations, particularly for growth stocks whose value depends on distant future cash flows.
Terminal Value Calculation
Since businesses operate indefinitely, a DCF model cannot project cash flows forever. Terminal value captures all cash flows beyond the projection period and typically represents 60 to 80 percent of total DCF valuation.
Perpetuity growth method
The most common approach assumes FCF grows at a constant rate forever. The formula is: Terminal Value = Final Year FCF x (1 + g) / (WACC - g), where g is the perpetual growth rate, usually set between 2 and 3 percent to approximate long-term GDP growth.
Exit multiple method
An alternative applies an EV/EBITDA or other multiple to the final year's metrics. This is simpler but introduces circular logic by using a market-based multiple within an intrinsic value framework.
Because terminal value dominates total valuation, even half a percentage point change in the growth rate assumption significantly alters the result.
Limitations of DCF
DCF is theoretically sound but practically challenging. Understanding its weaknesses helps investors use it more effectively.
- The most fundamental limitation is forecast uncertainty. Projecting cash flows five to ten years out requires assumptions about growth, margins, and competitive dynamics that may prove wrong. DCF models are only as good as their inputs.
- Terminal value sensitivity compounds this. Because it accounts for the majority of total value, small changes in the growth rate produce outsized effects. This makes DCF particularly unreliable for early-stage companies with unpredictable trajectories.
- DCF also struggles with businesses that lack consistent free cash flow. High-growth technology firms and cyclical businesses with volatile earnings are difficult to model. The method works best for mature businesses with predictable cash flow patterns.
- Finally, DCF provides a false sense of precision. Professional analysts address this by running sensitivity analyses across multiple scenarios rather than relying on a single point estimate.
Conclusion
DCF valuation offers the most rigorous framework for estimating what a business is truly worth. By focusing on future cash flows rather than market comparisons, it forces investors to evaluate the fundamental drivers of value.
Its sensitivity to assumptions means DCF should be used as one input alongside relative metrics like P/E and PEG ratios, not as a standalone verdict. The discipline of building a DCF, even an imperfect one, sharpens investment thinking.
FAQ
What is DCF valuation?
DCF estimates a company's intrinsic value by projecting future free cash flows and discounting them to present value using a required rate of return.
Why is terminal value so important in DCF?
Terminal value captures all cash flows beyond the projection period and typically accounts for 60 to 80 percent of the total valuation.
Is DCF reliable for all companies?
No. It works best for mature businesses with stable cash flows. It is less reliable for early-stage, high-growth, or highly cyclical companies.
References
- Investopedia, Discounted Cash Flow (DCF) Explained, 2026.
- Harvard Business School, Discounted Cash Flow (DCF) Formula: What It Is & How to Use It, 2026.
