Valuing a company with discounted cash flow (DCF)

The discounted cash flow (DCF) method values a company as the present value of the free cash flows it will generate in the future. The logic is simple: a company is worth the cash it will provide to its owners, and future cash is worth less than cash today. In practice the result is extremely sensitive to assumptions. In this article I walk through a DCF valuation with a hypothetical example and use a sensitivity table to show how much the answer depends on which assumptions.

The four building blocks of a DCF

1. A free cash flow projection: cash flows for an explicit forecast period, usually 5 to 10 years, calculated as operating cash flow less capital expenditure and the increase in working capital.
2. A discount rate: a rate reflecting the risk of those cash flows. When valuing the whole company, the weighted average cost of capital (WACC) is usually used.
3. A terminal value: the value, at the end of the explicit period, of all cash flows beyond it.
4. The bridge from enterprise value to equity value: net debt is deducted from enterprise value to arrive at the value attributable to shareholders.

For the definition and calculation of free cash flow see free cash flow, and for the cost of capital see capital structure and the cost of capital.

The discounted cash flow logic is not only used in buying and selling companies; it also appears in financial reporting. Under IAS 36, for example, “value in use”, which helps determine an asset’s recoverable amount, is calculated by discounting the future cash flows expected from the asset at an appropriate rate.

A hypothetical example

The company and all figures below are hypothetical; the discount and growth rates are chosen only to illustrate the method. In a real valuation they should be based on market data and the company’s risk profile.

The five-year free cash flow projection and its present value at a 20% discount rate:

The terminal value assumes cash flow grows at 5% a year after year five (the Gordon growth model):

• Year 6 cash flow = 44.0 × 1.05 = 46.2
• Terminal value at the end of year 5 = 46.2 / (0.20 − 0.05) = 308.0
• Present value of the terminal value = 308.0 × 0.4019 = 123.78

Enterprise value = 108.06 + 123.78 = about TRY 231.8 million. With net debt of TRY 50 million, equity value is about TRY 181.8 million.

The weight of the terminal value

In the example, about 53% of enterprise value comes from the terminal value. In growing companies it can reach 60–70%. That means more than half the value rests on a single assumption about the period after year five — the perpetual growth rate — together with the discount rate. So the terminal value calculation needs these checks:

• The perpetual growth rate should not exceed long-run nominal growth in the economy.
• Year-five cash flow should represent a “normal” year: an unusually high margin or temporarily low capital expenditure inflates the terminal value.
• The EBITDA multiple implied by the terminal value should be calculated and compared with transaction multiples for similar companies.

Sensitivity analysis

Presenting a DCF as a single number is misleading. The effect of reasonable changes in the discount rate and perpetual growth rate should always be shown. Enterprise value for the example company (TRY million):

A two-point change in the discount rate moves the value by roughly 12–16%. The table shows where the real debate in a valuation negotiation should happen: the realism of the cash flow projection and the basis of the discount rate.

Nominal and real consistency

A common mistake in high-inflation environments is to forecast cash flows in one currency and under one inflation assumption, then derive the discount rate from another currency or inflation expectation. The rule is simple: nominal cash flows are discounted at a nominal rate, real cash flows at a real rate, and the currency must be the same on both sides. A Turkish lira projection should not be discounted at a cost of capital built in US dollars.

Comparing DCF with other methods

DCF is a strong method because it reflects the company’s own cash-generating capacity, but it should not be used alone. In practice it is usually assessed alongside:

• Trading comparables: multiples such as EV/EBITDA for similar listed companies.
• Transaction comparables: multiples paid in acquisitions in the sector.
• Asset-based approaches: especially for asset-heavy companies or those facing liquidation risk.

A large gap between methods usually signals that one of the DCF assumptions departs markedly from market expectations and needs to be questioned again.

Common mistakes

• Forecasting high sales growth while keeping the capital expenditure and working capital that should accompany it low
• Treating an unusually high margin in the last explicit year as permanent in the terminal value
• Forgetting debt-like items (overdue tax liabilities, termination benefit obligations) when deducting net debt
• Settling for a single scenario

I showed with an example how the net debt definition affects the price in a transaction in financial due diligence in acquisitions.

Conclusion

The DCF method ties a company’s value to its future cash generation and is therefore only as reliable as its assumptions. Knowing the weight of the terminal value, always presenting the result with a sensitivity table and keeping nominal and real figures consistent make a valuation defensible. I cover the same logic applied to investment projects in NPV, IRR and payback. You can read about my valuation and financial modelling work on the FP&A page.