The Discounted Cash Flow (DCF) Model, Explained

The discounted cash flow (DCF) model values an asset by the cash it will generate in the future, discounted back to what that cash is worth today. It rests on one unarguable idea: a pound next year is worth less than a pound now, because of risk and the opportunity to invest. Master the DCF and you hold the central tool of valuation, capital allocation and M&A.

This guide builds the model up from first principles — free cash flow, the discount rate, terminal value — and then values a simple business end to end, so you can see exactly where the answer comes from and which assumptions actually move it.

The core idea: the time value of money

£100 received in one year is worth less than £100 today. If you could earn 8%, £100 next year is worth £100 ÷ 1.08 = £92.59 now. That divisor is discounting. A DCF applies it to every future year of cash flow and adds the results up. The present value of a cash flow CF in year n at discount rate r is CF ÷ (1 + r)ⁿ.

Step 1: Forecast free cash flow

The DCF uses free cash flow (FCF) — the cash a business generates after funding the investment needed to keep running and growing. Unlevered FCF (free cash flow to the firm) is the usual choice:

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

Forecasting FCF well means understanding the drivers of the business — revenue growth, margins, capex intensity and working-capital cycles — not just trending last year forward. This is where valuation meets financial modelling.

Step 2: Choose a discount rate (WACC)

The discount rate reflects the risk of the cash flows. For unlevered FCF, the standard is the weighted average cost of capital (WACC) — the blended cost of the company’s debt and equity, weighted by their proportions. A higher WACC means riskier cash flows and a lower valuation. Because WACC sits in the denominator for every year, it is one of the two assumptions that move the answer most.

Step 3: Calculate terminal value

You cannot forecast cash flow forever, so a DCF forecasts an explicit period (often 5–10 years) and then captures everything beyond it as a single terminal value. Two methods dominate:

• Perpetuity growth (Gordon growth): TV = FCF_final × (1 + g) ÷ (WACC − g), where g is the long-term growth rate — usually no higher than long-run GDP growth.
• Exit multiple: apply a sensible EV/EBITDA multiple to the final-year figure, grounded in comparable transactions.

In most DCFs, the terminal value is the majority of the answer. Treat the growth rate and discount rate with the suspicion they deserve.

A worked example

A business generates £10m of FCF next year, growing 5% a year for five years. WACC is 9%; long-term growth beyond year five is 2%.

Sum of discounted explicit cash flows ≈ £42.6m. Terminal value = 12.16 × 1.02 ÷ (0.09 − 0.02) = £177.2m, discounted at 0.650 → £115.2m. Enterprise value ≈ £42.6m + £115.2m = £157.8m. Notice the terminal value is roughly 73% of the total — which is exactly why the long-term assumptions matter more than the year-three forecast.

Strengths and limitations

The DCF’s strength is that it is grounded in fundamentals rather than market sentiment, and it forces you to articulate what you actually believe about a business. Its weakness is sensitivity: it is famously easy to engineer any answer you like by nudging WACC and terminal growth. The remedy is a sensitivity table — show the valuation across a range of discount and growth rates — and pairing the DCF with market-based comparables. A valuation expressed as a single number invites false confidence; a valuation expressed as a defensible range invites a better conversation.