ValueHow a DCF works (and what to watch for)
A discounted cash flow model answers one question: what is this business worth today, given the cash it will generate in the future? The logic has three steps:
- Forecast free cash flow for a set number of years, growing at your assumed rate.
- Add a terminal value for everything after the forecast, usually with the Gordon Growth formula: final-year FCF × (1 + terminal growth) ÷ (WACC − terminal growth).
- Discount everything to today at the WACC, subtract net debt, divide by shares outstanding.
The terminal value usually makes up 60-80% of the total. That is normal, but it means your terminal growth and discount rate assumptions dominate the answer — which is exactly why the sensitivity table above matters more than any single headline number.
Choosing sensible inputs
- Growth: compare your assumption to the company's historical CAGR and the industry's growth. Sustained 20%+ growth is rare; be skeptical of your own optimism.
- WACC: build it properly with the WACC calculator rather than guessing. A 1-point change in WACC can move the valuation 10-20%.
- Terminal growth: 2-3% for developed markets. Anything above long-run GDP growth implies the company eventually becomes larger than the economy.
- Free cash flow: operating cash flow minus capex. For cyclical or currently unprofitable companies, normalize across a cycle or use a mid-cycle estimate.
Limitations
- Garbage in, garbage out: the model amplifies whatever growth and discount assumptions you feed it.
- It assumes the business survives and grows smoothly; it handles disruption, dilution, and cyclicality poorly.
- Use it as a range (Bear/Base/Bull) and cross-check with reverse DCF (what is the market pricing in?) and margin of safety before any decision.
Frequently asked questions
What is the terminal value in a DCF?
It is the estimated value of all cash flows beyond your explicit forecast period, usually computed with the Gordon Growth formula. Because it captures "forever," it often represents most of the calculated value — so small changes in terminal growth or WACC move the result a lot.
What discount rate should I use?
Start with the company's WACC (try the WACC calculator). Typical ranges: 7-10% for large stable companies, 10-14%+ for smaller or riskier ones. The rate must stay above your terminal growth rate.
Why do DCF valuations vary so much between analysts?
Most of the disagreement lives in two inputs: the growth assumption and the discount rate. Two reasonable analysts can easily differ 30-50% on the same company. Treat any DCF as a range, not a point estimate.
Can I use a DCF for a company with negative cash flow?
Not directly — the math needs positive cash flows to grow. Common workarounds: normalize to mid-cycle earnings, or forecast the path to profitability first. Be extra conservative with the growth rate in these cases.
How accurate is a DCF valuation?
A DCF is only as good as its inputs, so treat the result as a range rather than a precise price. Small changes in the growth rate or discount rate can move the answer 30 to 50 percent, which is why this page shows Bear, Base, and Bull scenarios plus a sensitivity table. Use it to test whether a stock still looks cheap under pessimistic assumptions.