The discounted cash flow (DCF) analysis is one of the most important valuation methods in finance. Among the commonly used valuation models, the DCF method belongs to the income-based approaches.
It complements market-based methods like multiples or transaction analyses as well as asset-based approaches like the net asset value. The DCF method is one of the most frequently used models in practice, especially in investment banking, private equity, and strategic corporate valuation.
The core idea of the DCF analysis is to determine the present value of a company based on the future cash flows it will generate. Instead of relying on past profits, the method uses expected free cash flows as the basis for valuation. These cash flows are discounted to their present value using an appropriate rate, the so-called WACC (Weighted Average Cost of Capital), in order to calculate the enterprise value.
At the beginning of any DCF analysis, the objective must be clearly defined. Are you valuing the entire company or just a business unit? Is it a single project, an acquisition, or a division? This objective determines which financial metrics must be considered and which cash flows are included.
For example, if you're working for a company considering building a new plant in Southeast Asia, you must first define what exactly is being analyzed:
This definition is crucial as it determines the relevant financial data and assumptions. Whether you’re valuing a company, a division, or a project, the required inputs differ significantly.
Next, analysts evaluate the financial situation of the target and identify key performance indicators (KPIs) for the cash flow forecast. These KPIs form the backbone of the DCF model. The stronger and more realistic the assumptions, the more reliable the result.
The most important KPIs include:
These metrics are often based on a mix of historical financials, internal planning, and market assumptions. Integrated financial models that link P&L, balance sheet, and cash flow statement are commonly used, especially for larger firms or institutional investors.
Depending on the industry, additional KPIs might be critical. In software, for instance, CAC (Customer Acquisition Cost) and CLV (Customer Lifetime Value) are key. In capital-intensive sectors, utilization rates, maintenance costs, or price-volume effects matter more. Other metrics like ARPU (Average Revenue per User), churn rate, or net revenue retention may also be relevant depending on the business model.
It’s also important to align KPIs with strategic value drivers: investments in growth, margin improvements, or working capital optimization all directly impact the cash flow profile. Thinking like an investor means linking metrics to long-term value.
Interviewers often ask how to derive KPIs from the P&L and balance sheet or which assumptions are most sensitive. Plausibility checks are expected: Do forecast margins align with history? Are growth rates realistic for the sector? Do investment plans match revenue expectations?
After defining the objective and identifying KPIs, the core of the DCF model follows: projecting future free cash flows. This means estimating how much cash the company will have available over the coming years, after paying operating costs, making necessary investments, and adjusting working capital.
Typically, a five- to ten-year forecast period is used. Each year’s free cash flow is estimated based on actual cash movement, not just accounting profits.
What is free cash flow? Free cash flow (FCF) is the cash a company has left after all operating and investing activities. It can be distributed to shareholders or used to pay down debt. The calculation involves several steps:
This results in the free cash flow for a given year.
Why is this forecast so important? The entire DCF model hinges on future cash flows. The better the forecast, the more reliable the valuation. However, predicting the future is difficult, so assumptions must be well-grounded.
Common questions include:
Because projections are assumption-driven, transparency is essential. Professional models often include multiple scenarios (e.g., base, growth, and downside) to show a range of possible outcomes.
Once the future cash flows are projected, the question becomes: what are those cash flows worth today? To find out, they are discounted back to present value using a discount rate – usually the Weighted Average Cost of Capital (WACC).
WACC reflects the average cost of capital for a company, combining the required return on equity with the cost of debt, weighted by their respective proportions in the capital structure. The higher the WACC, the lower the present value of future cash flows. Here is how to calculate it:
Estimate how the company is typically financed (debt vs. equity). Use historical data, peer comparisons, or strategic targets.
This reflects the interest rates at which the company can borrow, adjusted for tax benefits:
Use current market rates, not historical loan terms.
Where:
Why is WACC important? WACC significantly influences the valuation: a lower WACC increases present value and vice versa. Even a 1% change can shift enterprise value considerably, making precise and reasonable calculation critical.
After forecasting free cash flows for the explicit forecast period (usually 5 to 10 years), one big question remains: What happens after that? Companies don't just stop operating. That’s where the terminal value (TV) comes in.
The terminal value captures the company’s value beyond the forecast period – often accounting for more than half of the total DCF value. So, calculating it carefully is crucial.
There are two main methods:
Assumes the company is sold at the end of the forecast period, like a private equity exit. The sale price is based on a market multiple (e.g., EV/EBITDA or EV/EBIT).
Example: If EBITDA in the final year is $50 million and the multiple is 10x, terminal value = $500 million.
Important:
This method is popular in private equity due to its deal-based logic.
👉 For a step-by-step guide, check our article on multiples.
Assumes the company continues to operate and grow at a constant rate indefinitely after the forecast period.
Where:
What to consider:
👉 See our Gordon Growth Model article for examples and detailed explanations.
Which method should you choose? Both are valid. It depends on context:
| Aspect | Exit Multiple | Perpetuity Growth |
| Use case | Private equity, exit scenarios | Long-term valuation |
| Data | Market multiples | FCF growth + WACC |
| Pros | Market-oriented, practical | Theoretical soundness |
| Cons | Depends on comparables | Highly sensitive to g and r |
Interview tip: If asked which method you prefer, a good answer is: "It depends. If reliable multiples are available, I use the exit method. For stable business models, I prefer the perpetuity growth approach. Ideally, I calculate both and compare."
Once all future free cash flows and the terminal value have been projected and discounted to their present value using the WACC, these values are added together to determine the total value. The result is the Enterprise Value (EV): the total value of the company’s operating business, independent of its capital structure.
The Enterprise Value thus reflects the value available to all capital providers (both equity and debt holders).
To calculate the Equity Value you subtract the company’s net debt from the Enterprise Value:
Net debt is typically calculated as:
The Equity Value is ultimately the key figure for shareholders or potential investors, as it reflects the portion of the company they “own.”
In professional financial models, the equity value is often shown per share, making it easier to compare to the current share price. For private companies, the value serves as a basis for purchase negotiations, financing decisions, or exit planning.
However, this value is only as reliable as the assumptions behind it. That’s why a final and critical step follows the valuation: the sensitivity analysis.
The DCF method is a powerful tool, but it stands or falls with the assumptions it’s built on. Even small changes in key parameters, such as the WACC, the terminal growth rate, or margin assumptions can significantly alter the company's valuation.
Because DCF analysis relies on forecasts and estimates, sensitivity analysis is one of the most important final steps. It helps to visualize the effects of uncertainties and shows how robust your valuation really is.
What do you do in a sensitivity analysis?
In a sensitivity analysis, you systematically vary individual input parameters and observe how the calculated company value (typically the equity value) changes. The goal is to identify key value drivers and make potential risks or fluctuations transparent.
Typical formats include:
Practical example
In many models, the terminal value accounts for over 60% of the total company value. This means: a seemingly minor change in the assumed terminal growth rate, from, say, 1.5% to 2.5%, can shift the equity value by 15% to 30%.
That’s why you should always test and clearly communicate these assumptions.
The Discounted Cash Flow (DCF) method is one of the most detailed and flexible valuation tools in finance. However, because it relies heavily on assumptions, even small errors can lead to big changes in results.
To make the DCF method more tangible, let’s walk through a simple but realistic scenario:
A company is planning to build a new production facility. The planned investment costs amount to 15 million USD, which will be incurred at the start of the project. The facility is expected to operate for six years before being decommissioned or replaced.
The company has estimated the following annual net free cash flows for the operating period:
| Year | Expected Free Cash Flow |
| 1 | 2.5 million USD |
| 2 | 3.5 million USD |
| 3 | 4.5 million USD |
| 4 | 5.5 million USD |
| 5 | 6.5 million USD |
| 6 | 7.5 million USD |
To value the investment, the company uses a WACC of 8%. This is the minimum return required to make the project attractive to capital providers.
To determine the present value of future cash flows, we apply the DCF formula to each individual payment:
Where:
| Year | Cash Flow (USD) | Discount Factor | Present Value (USD) |
| 1 | 2,500,000 | 1.08 | 2,314,815 |
| 2 | 3,500,000 | 1.1664 | 3,000,686 |
| 3 | 4,500,000 | 1.2597 | 3,571,800 |
| 4 | 5,500,000 | 1.3605 | 4,042,632 |
| 5 | 6,500,000 | 1.4693 | 4,423,195 |
| 6 | 7,500,000 | 1.5869 | 4,726,196 |
Total DCF Value = 22,079,324 USD
The DCF value reflects the total present value of future cash flows but doesn’t yet account for the initial investment. To determine the project's profitability, we subtract the initial outlay:
A positive Net Present Value (NPV) of about 7.08 million USD means that the expected cash flows significantly exceed the initial investment. In other words, the project would create value above the required 8% return.
Since the actual return is higher than the WACC, the project generates economic value added from the perspective of capital providers. From the company’s standpoint, this investment contributes to sustainable value creation, a core goal of any sound financial decision.
Questions about the Discounted Cash Flow analysis are standard in interviews for finance roles, especially in investment banking and private equity. Below are some of the most frequently asked DCF-related questions and how you might answer them:
A DCF valuation calculates a company’s value by determining the present value of its expected future cash flows.
The formula for WACC is:
Where:
Each component is weighted according to its proportion in the capital structure.
It depends, but in most cases, a 10% change in revenue has a bigger impact.
Why? Because revenue changes affect not only one year’s cash flows but also future years and the Terminal Value, which often makes up the bulk of a DCF valuation.
| Pros of DCF Valuation | Cons of DCF Valuation |
| Provides a fundamental assessment of value based on future expectations. | Heavily reliant on assumptions, small errors can lead to major misvaluations. |
| Highly flexible and adaptable to different scenarios and assumptions. | Requires deep financial expertise and high-quality data inputs. |
👉 You can practice these and many more questions with our cases on the DCF Analysis, so check it out now!
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The Discounted Cash Flow (DCF) method is a powerful way to value a company by looking at its future potential rather than its past performance. Instead of focusing on historical profits or comparing with other firms, it estimates how much cash the company is expected to generate in the future based on factors like revenue growth, profit margins, investments, and working capital.
DCF is especially helpful when you want a valuation that is independent of market mood or short-term trends, such as when making investment decisions, planning acquisitions, or developing long-term strategies.
However, DCF is not a plug-and-play formula. It is a framework that helps you think through a company’s value logically, but its accuracy depends on how realistic your assumptions are.
That’s why it’s important to stay transparent about your inputs, question your assumptions, and perform a sensitivity analysis to see how small changes could affect your results. This way, you can show how reliable your valuation really is.
