How to Build a Discounted Cash Flow Model: 6-Step Framework

The Discounted Cash Flow (DCF) model is one of the most widely used valuation techniques in finance. It provides a method to determine the intrinsic value of a company or asset based on its projected future cash flows. Unlike relative valuation methods such as multiples, the DCF model is grounded in the fundamental financial performance of the business, making it particularly valuable for investors, analysts, and corporate finance professionals.

Building a DCF model may seem complex, but when broken down into a structured six-step framework, it becomes manageable and precise. This guide will provide a step-by-step roadmap to create a robust DCF model, while highlighting critical considerations to ensure accuracy and reliability.

Step 1: Forecast Free Cash Flows (FCF)

The first step in building a DCF model is to project the company’s free cash flows. Free Cash Flow represents the cash generated by a company after accounting for capital expenditures required to maintain or expand its asset base. It is the cash available to all investors, including equity and debt holders.

How to Forecast FCF:

1. Start with Revenue Projections: Analyze historical revenue growth rates, market trends, and industry forecasts. Consider macroeconomic factors that may influence growth, such as inflation or changing consumer behavior.
   
2. Estimate Operating Expenses: Subtract costs of goods sold (COGS), selling, general, and administrative expenses (SG&A), and research and development (R&D) costs from revenue.
   
3. Calculate Operating Income (EBIT): Earnings before interest and taxes (EBIT) is derived from revenue minus operating expenses.
   
4. Adjust for Taxes: Multiply EBIT by (1 – tax rate) to obtain Net Operating Profit After Taxes (NOPAT).
   
5. Subtract Capital Expenditures (CapEx) and Add Depreciation: CapEx reduces cash flow, while depreciation is a non-cash expense that should be added back.
   
6. Adjust for Changes in Working Capital: Include increases or decreases in current assets and liabilities that impact cash flow.

Formula for Free Cash Flow (FCF):

FCF=NOPAT+Depreciation−CapEx−ΔWorking CapitalFCF = NOPAT + Depreciation – CapEx – \Delta Working\ CapitalFCF=NOPAT+Depreciation−CapEx−ΔWorking Capital

Expert Tip: Forecast FCF for at least 5–10 years to capture the company’s growth trajectory and operational dynamics accurately.

Step 2: Determine the Discount Rate

Discounting is at the core of the DCF model. The discount rate accounts for the time value of money and risk associated with future cash flows. Choosing an appropriate discount rate is critical because it directly influences the valuation outcome.

Common Discount Rate Choices:

1. Weighted Average Cost of Capital (WACC): Most commonly used for firm valuation. WACC represents the blended cost of equity and debt financing, weighted according to the company’s capital structure.
   
   • Formula:
     
2. WACC=EV×Re+DV×Rd×(1−TaxRate)WACC = \frac{E}{V} \times Re + \frac{D}{V} \times Rd \times (1 – TaxRate)WACC=VE​×Re+VD​×Rd×(1−TaxRate)
   • E = Market value of equity
     
   • D = Market value of debt
     
   • V = E + D (Total firm value)
     
   • Re = Cost of equity
     
   • Rd = Cost of debt
     
3. Cost of Equity (Ke): For equity valuation, the cost of equity is calculated using the Capital Asset Pricing Model (CAPM):
   Ke=Rf+β×(Rm−Rf)Ke = Rf + \beta \times (Rm – Rf)Ke=Rf+β×(Rm−Rf)
   • Rf = Risk-free rate
     
   • β = Beta (systematic risk)
     
   • Rm = Expected market return
     

Expert Tip: Ensure the discount rate reflects both market risks and company-specific risks. Using an inaccurate rate can result in a misleading valuation.

Step 3: Forecast the Terminal Value

The terminal value (TV) accounts for the company’s cash flows beyond the explicit forecast period. Since it is impossible to forecast FCF indefinitely, the terminal value represents the present value of all future cash flows beyond the forecast horizon.

Common Terminal Value Methods:

1. Perpetuity Growth Method: Assumes cash flows grow at a constant rate forever.
   TV=FCFn×(1+g)WACC−gTV = \frac{FCF_{n} \times (1 + g)}{WACC – g}TV=WACC−gFCFn​×(1+g)​
   • FCFn_nn​ = Free cash flow in the final forecast year
     
   • g = Perpetual growth rate (usually 2–3% for mature companies)
     
   • WACC = Discount rate
     
2. Exit Multiple Method: Values the company based on a multiple of financial metrics such as EBITDA or EBIT.
   TV=Metricn×Exit MultipleTV = Metric_{n} \times Exit\ MultipleTV=Metricn​×Exit Multiple

Expert Tip: Choose a growth rate aligned with long-term economic expectations. Overly optimistic assumptions can inflate valuations unrealistically.

Step 4: Discount Cash Flows to Present Value

Once the FCF and terminal value are projected, the next step is to discount them to their present value. Discounting adjusts future cash flows for risk and time value, enabling a proper valuation in today’s terms.

Discounting Formula:

PV=FCFt(1+r)tPV = \frac{FCF_t}{(1 + r)^t}PV=(1+r)tFCFt​​

• PV = Present Value
  
• FCFt_tt​ = Free cash flow in year t
  
• r = Discount rate
  
• t = Year number

Steps:

1. Discount each year’s FCF to present value using the chosen discount rate.
   
2. Discount the terminal value to present value using the same rate.
   
3. Sum the discounted FCFs and discounted terminal value to get the total enterprise value (EV).

Expert Tip: Ensure consistency by using the same discount rate for both the explicit forecast period and terminal value.

Step 5: Calculate the Equity Value

After obtaining the enterprise value (EV), the next step is to derive the equity value. Enterprise value represents the value of the firm to all investors, while equity value represents the value attributable to shareholders.

Steps to Calculate Equity Value:

1. Subtract Net Debt:
   

Equity Value=Enterprise Value−Net DebtEquity\ Value = Enterprise\ Value – Net\ DebtEquity Value=Enterprise Value−Net Debt

• Net Debt = Total Debt – Cash and Cash Equivalents
  

2. Adjust for Minority Interests or Preferred Stock: If applicable, subtract minority interests and preferred stock to refine the equity value.

Expert Tip: Carefully consider debt, cash, and other liabilities. Misestimating net debt can significantly affect equity value.

Step 6: Perform Sensitivity Analysis

DCF valuations are highly sensitive to assumptions, particularly the discount rate and terminal growth rate. A small change can result in a significant difference in estimated value.

How to Conduct Sensitivity Analysis:

1. Create a table varying the discount rate and terminal growth rate.
   
2. Calculate a range of possible valuations.
   
3. Analyze how valuation changes under different scenarios to understand potential risks.

Expert Tip: Sensitivity analysis enhances confidence in valuation results by providing a range rather than a single-point estimate.

Conclusion

Building a DCF model is both an art and a science. By following the six-step framework forecasting free cash flows, determining the discount rate, projecting terminal value, discounting cash flows, calculating equity value, and performing sensitivity analysis analysts can generate a valuation that reflects a company’s true intrinsic worth.

A robust DCF model requires accurate data, realistic assumptions, and careful judgment. While it provides powerful insights, it should be used in conjunction with other valuation methods for a comprehensive investment decision. With practice, a well-constructed DCF model becomes an invaluable tool in financial analysis, strategic planning, and investment evaluation.