FINANCE · BUSINESS VALUATION
Discounted Cash Flow (DCF) Valuation: Formula and Worked Example
Discounted cash flow valuation estimates value by converting expected future cash flows into a present amount. A DCF model makes the relationship between operating performance, reinvestment, risk, and long-term assumptions visible. Its result is an estimate conditional on those assumptions, not a guaranteed sale price.
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What a DCF model contains
- Forecast cash flow: Translate revenue, margins, taxes, investment, and working-capital assumptions into future free cash flow.
- Discount rate: Estimate a rate consistent with the cash flow’s risk, currency, timing, and inflation basis.
- Terminal value: Estimate the value of cash flows after the explicit forecast ends.
- Present value: Discount both the explicit cash flows and terminal value to the valuation date.
- Equity bridge: Reconcile operating value to the value attributable to shareholders.
The three-statement forecast guide helps connect operating assumptions to cash. Time value of money explains discounting, while NPV applies the same present-value logic to investment decisions.
The FCFF valuation formula
Operating value today = Σ [FCFFt ÷ (1 + WACC)t] + TVn ÷ (1 + WACC)n
The sum covers years 1 through n. TVn is terminal value measured at the end of year n, not today. For a constant-growth terminal model:
TVn = FCFFn+1 ÷ (WACC − g)
The terminal growth rate g must be below WACC. It must also be economically sustainable. Merely choosing a growth rate below WACC does not make the forecast credible.
Worked example: value the operating business
This original hypothetical annual model starts with year-1 FCFF of $55,000, the measure calculated in the Free Cash Flow guide. Forecast FCFF then reaches $60,000 in year 2 and $65,000 in year 3. Assume year-end cash flows, a constant 10% WACC, and a sustainable 3% annual growth rate after year 3. These are illustrative inputs, not market benchmarks.
Assume all stated FCFF amounts already deduct the reinvestment needed to support their growth. In practice, a three-year forecast is often too short to establish stable operations; this shortened example is for teaching. Extend the forecast or model a transition where required.
| Year | FCFF | Discount calculation | Present value |
|---|---|---|---|
| 1 | $55,000 | $55,000 ÷ 1.10 | $50,000.00 |
| 2 | $60,000 | $60,000 ÷ 1.10² | $49,586.78 |
| 3 | $65,000 | $65,000 ÷ 1.10³ | $48,835.46 |
| Explicit forecast total | — | Sum using unrounded values | $148,422.24 |
Calculate and discount terminal value
First estimate year-4 cash flow: $65,000 × 1.03 = $66,950. Then calculate the value of all cash flows from year 4 onward as of the end of year 3:
TV3 = $66,950 ÷ (10% − 3%) = $956,428.57
Discount that year-3 value back three years:
PV of terminal value = $956,428.57 ÷ 1.10³ = $718,578.94
Operating value = $148,422.24 + $718,578.94 = $867,001.18
Use unrounded values in the model. Terminal value represents approximately 82.9% of this operating value. That concentration means the long-term growth, reinvestment, and risk assumptions deserve substantial scrutiny. Do not mistake a detailed short-term forecast for certainty about the distant future.
Bridge operating value to equity value
Assume the business holds $20,000 of excess cash outside the operating cash flows and has debt with a current value of $200,000. There are no other nonoperating assets or senior claims in this simplified example.
| Bridge item | Amount |
|---|---|
| Value of operating assets | $867,001.18 |
| Add excess cash | +$20,000.00 |
| Subtract debt | −$200,000.00 |
| Estimated equity value | $687,001.18 |
Only add cash or assets that have not already been valued through operating cash flows. An actual bridge may include preferred shares, noncontrolling interests, leases, pension obligations, investments, and other claims. Their treatment must be consistent with the operating forecast and discount rate. A share value also requires a supported share count and treatment of dilution.
Test the valuation range
The table shows operating value, rounded to whole dollars, as WACC and terminal growth change. The three explicit FCFF amounts remain fixed. These are mechanical sensitivities, not a probability distribution.
| WACC | Terminal growth 2% | Terminal growth 3% | Terminal growth 4% |
|---|---|---|---|
| 9% | $882,520 | $1,012,780 | $1,195,144 |
| 10% | $771,074 | $867,001 | $994,904 |
| 11% | $684,419 | $757,690 | $851,896 |
Go deeper on terminal assumptions
Read Terminal Value: Perpetuity Growth vs. Exit Multiple for a separate worked example, timing checks, and sensitivity table. Its illustrative dataset is separate from the example on this page.
Subtract the same net debt of $180,000 to obtain equity values for this illustration. Growth changes may require different reinvestment and risk assumptions in a full scenario. Use scenario analysis to test those connected effects.
Check the model before relying on it
- Cash flow: Use cash after operating taxes and required reinvestment. EBITDA is not FCFF.
- Financing: Do not deduct debt interest and principal from FCFF while also using WACC.
- Terminal timing: Use year n+1 cash flow in the growth formula and discount terminal value from year n.
- Long-term economics: Support growth with reinvestment, realistic returns, and an appropriate mature risk profile.
- Consistency: Match nominal with nominal, real with real, and the rate period with cash-flow timing.
- Equity bridge: Reconcile cash, debt, and other claims without double counting.
Frequently asked questions
Is enterprise value the same as equity value?
No. The operating value estimated from FCFF concerns the operating assets available to capital providers. Equity value is the residual after a consistent bridge for nonoperating assets and other claims. State exactly what any quoted “enterprise value” includes.
Can I use an exit multiple instead?
An exit multiple is another terminal-value approach, but it imports assumptions from comparable market pricing. Explain the metric, multiple, and implied long-term economics. It is not an independent guarantee of value.
Does the model tell me what a buyer will pay?
No. Negotiations, financing, synergies, control rights, market conditions, and transaction terms can change an actual price. DCF is one analytical input.
Sources and learning notes
Further reading: Aswath Damodaran’s valuation materials and Estimating Terminal Value. All business figures, forecasts, and sensitivity tables are original hypothetical teaching examples.