How much is a company really worth? The discounted cash flow (DCF) model helps answer that question by estimating the present value of the cash a business is expected to generate in the future.
To make that estimate, the model uses financial forecasts to project the company’s future cash flows.
Another valuation method is the discounted dividend model (DDM), which estimates a stock’s value based on its expected future dividends. Although DCF and DDM use different measures, both apply the time value of money to estimate what future cash flows are worth today.
“Within a company, well-informed valuation enables managers to make wiser decisions regarding capital budgeting and strategic planning,” says Harvard Business School Professor Suraj Srinivasan in the online course Strategic Financial Analysis. “Outside the company, investors need to measure value to assess the risks and returns of their investments with greater confidence.”
In this guide, you’ll learn how the DCF model works, how to calculate it, and how to use it to make more informed investment and strategic decisions.
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What Is Discounted Cash Flow (DCF)?
The discounted cash flow (DCF) model estimates a company’s intrinsic equity value by discounting projected future free cash flows to equity (FCF ͤ) using the time value of money principle.
To break that down:
Equity value: The total value of a company’s shares, representing shareholder ownership
Present value: The current value of an expected future financial return, usually a sum of money; it’s what your future money would be worth today.
Free cash flow to equity (FCF ͤ): Funds available to shareholders, regardless of whether they’re distributed; this differs from dividends, which a company must return to its shareholders
Time value of money: The principle that a sum today is worth more than in the future due to its potential earning capacity
“A DCF analysis is useful when investing money now and expecting some rewards in the future,” Srinivasan says in Strategic Financial Analysis. “A DCF analysis finds the intrinsic value of a business, which is the present value of the free cash flow the company is expected to pay its shareholders in the future. If the intrinsic value is higher than the current price, it could be a good investment opportunity.”
How Does Discounted Cash Flow (DCF) Work?
Strategic Financial Analysis teaches the DCF equation. At its core, the formula estimates a company’s value by discounting its projected future cash flows to their present value. In practice, analysts typically forecast cash flows over a defined period and add the present value of a terminal value representing cash flows beyond that period.
For an equity valuation, the formula is:
Equity Value = Present Value of Future Free Cash Flow to Equity
V₀ = FCF ͤ₁ / (1+ re )¹ + FCF ͤ₂ / (1+ re ) ² + FCF ͤ₃ / (1+ re )³ + ...
= ∑ from t = 1 to ∞ FCF ͤₜ / (1+ re )ᵗ
Although the equation may look complex, DCF applies the same basic calculation to each projected period. Here’s a breakdown of its key components:
V₀ = The company’s equity value, or the value of all its shares
FCF ͤ = Estimated free cash flow to equity for a specific future period
re = The required rate of return on equity, or cost of equity, used as the discount rate
t = The future period in which each cash flow is expected to occur; DCF forecasts typically span five to 10 years
Steps to Perform a DCF Analysis:
Estimate your company’s free cash flows to equity (FCF ͤ) over a defined period, typically five to 10 years.
Estimate the company’s terminal value, which represents its value beyond the last year of the forecast period.
Establish the discount rate (rₑ ), or cost of equity; this reflects the return investors require for holding the company’s equity.
Discount the projected free cash flows and terminal value to their present values using the time value of money, then sum them to determine the company’s intrinsic equity value.
How to Calculate Terminal Value
The terminal value represents a company’s estimated value beyond the forecast period. One common method for calculating it is the Gordon Growth Model, which assumes the company continues to grow at a stable rate:
Present Value of Stock = V₀ = FCF ͤ / re - g
This equation starts with the estimated future free cash flow of the first year after your specified time frame (FCF ͤ). Then, it’s divided by the difference between the discount rate (re) and the estimated growth rate (g).
How to Calculate Discounted Cash Flow
To see the formula in action, consider a simple example.
Imagine you’re considering buying an apple tree for $200. You estimate that the tree will generate $100 in free cash flow each year indefinitely and want to determine whether the investment is worthwhile.
Because money today is worth more than money received in the future, you must discount the tree’s future cash flows. Assume a 10 percent discount rate and no long-term growth.
Year 1 apples: $100 / (1+0.1) = $90.91
Year 2 apples: $100 / (1+0.1)² = $82.64
Year 3 apples: $100 / (1+0.1)³ = $75.13
Year 4 and beyond apples: $100 / (0.1) = $1,000
The $1,000 represents the value of the tree’s cash flows from Year 4 onward at the end of Year 3. To determine its present value, you must discount it back three years:
$1,000 / (1 + 0.1)3 = $751.31
As you go through the formula, you’ll notice the denominator increases due to the compounding effects of the discount rate year over year.
Once you’ve calculated the present values of each year’s cash flow, you add them together:
$90.91 + $82.64 + $75.13 + $751.31 = $999.99
Since the total present value ($999.99) exceeds the cost of the tree ($200), the investment is worthwhile.
This example demonstrates how DCF accounts for the time value of money: cash flows received further in the future are worth less today.
DCF Benefits and Drawbacks
One benefit of discounted cash flow (DCF) analysis is that it estimates the intrinsic value based on a company’s expected future cash flows. However, because DCF relies on forecasts and assumptions, its results can vary significantly based on the inputs used.
The appropriate discount rate depends on the type of cash flow being valued:
Cost of equity, also known as the cost of equity capital (Re): The return shareholders require to invest in a company's stock. It's often determined using the capital asset pricing model (CAPM), which adds the risk-free rate to a premium based on the stock’s sensitivity to market movements, known as “beta.”
Weighted average cost of capital (WACC): The company’s weighted average cost of debt and equity financing. WACC is used to discount free cash flow to the firm.
Because DCF relies on future performance estimates, it’s highly sensitive to even small assumption changes, including projected cash flows, discount rates, and long-term growth rates.
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Using DCF to Evaluate Future Valuations
By valuing future cash flows, you can make more strategic investment decisions. The discounted cash flow (DCF) model helps estimate your company’s intrinsic value based on its expected future cash flows.
You can deepen your understanding of DCF and other valuation methods, including the discounted dividend model (DDM), by taking an online finance course like Strategic Financial Analysis. The course explores the intersection of accounting, strategy, and finance through interactive exercises and real-world business examples to enhance your learning.
Ready to strengthen your financial management, analysis, and decision-making skills? Explore Strategic Financial Analysis—one of our online finance and accounting courses—to leverage financial insights to drive strategic decision-making. Get a jump start by downloading our free Financial Terms Cheat Sheet.
This post was updated on September 4, 2026. It was originally published on March 4, 2025.