What Is Discounted Cash Flow? How to Create a DCF Model

What Is Discounted Cash Flow (DCF)?

Discounted Cash Flow (DCF) is a valuation method that estimates the intrinsic value of a company or asset by projecting its future cash flows and discounting them back to their present value. Instead of relying on market hype, price momentum, or temporary earnings, the Discounted Cash Flow method focuses on fundamental cash-generating ability.

Investors use DCF to answer a simple yet powerful question:

“What is the business truly worth today based on the cash it will produce tomorrow?”

Because of this, DCF is widely used in equity research, corporate finance, private equity, and long-term investing.

If you’ve ever wondered what is discounted cash flow or how analysts determine whether a stock is undervalued or overvalued, DCF is one of the most reliable ways to make that assessment.

Why DCF Is One of the Most Reliable Valuation Methods?

DCF is considered one of the most robust valuation models because:

• It focuses on future cash flows, not short-term profits.

• It accounts for the time value of money, recognizing that ₹1 earned today is worth more than ₹1 earned later.

• It forces analysts to think about growth, profitability, reinvestment, and risk.

• It delivers a quantitative estimate of intrinsic value, enabling better buy/sell decisions.

Unlike relative valuation methods such as P/E or P/B ratios—which compare a company to peers—DCF gives a standalone estimate based solely on the company’s own performance potential.

Key Components of a Discounted Cash Flow Model

A complete DCF model includes:

1. Forecast Period

Usually 5–10 years of projected free cash flows.

2. Free Cash Flow (FCF)

Analysts typically use Free Cash Flow to Firm (FCFF):

FCFF = EBIT (1 − Tax Rate) + Depreciation − CapEx − Changes in Working Capital

3. Discount Rate

Most models use WACC (Weighted Average Cost of Capital) because it reflects business risk and cost of capital.

4. Terminal Value

Value of cash flows after the forecast period, usually calculated using:

• Gordon Growth Method, or
• Exit Multiple Method.

5. Present Value Calculation

All future cash flows are discounted back using WACC to arrive at the intrinsic value.

Together, these components form the backbone of a well-structured Discounted Cash Flow model.

The Discounted Cash Flow Formula

Here is the standard DCF formula:

DCF = ∑t = {FCFt / (1+r)^t} + {TV / (1+r)^n}

​Where:

• FCFt​ = Free Cash Flow in year t
• r = Discount rate (often WACC)
• TVTVTV = Terminal value
• n = Number of forecast years

This discounted cash flow formula brings all future cash flows to their value today.

How to Calculate Discounted Cash Flow?

Building a DCF involves the following steps:

Step 1: Project Future Cash Flows

Estimate free cash flow for 5–10 years based on:

• Revenue growth
• Operating margins
• Tax impact
• Capital expenditure
• Working capital changes

Step 2: Calculate Discount Rate (WACC)

This accounts for debt cost, equity cost, beta, and capital structure.

Step 3: Estimate Terminal Value

Using a long-term growth rate (typically 2–5%).

Step 4: Discount All Cash Flows

Use the discounted cash flow method to compute present value.

Step 5: Compare Intrinsic Value With Market Price

This helps determine:

• Undervalued: Intrinsic value > Market value

• Overvalued: Market value > Intrinsic value

Real Example: Discounted Cash Flow (DCF) Model in Action

Let’s take a simplified example to demonstrate how a DCF model works.

Assumptions

• Forecast free cash flows for next 3 years:

• Year 1: ₹120 crore

• Year 2: ₹140 crore

• Year 3: ₹160 crore

• Discount rate (WACC): 10%

• Terminal growth rate: 4%

Step 1: Discount Each Cash Flow

PV1 = 120 / 1.10 = 109.1

PV2 = 140 / 1.10^2 = 115.7

PV3=160 / 1.10^3 = 120.1

Step 2: Calculate Terminal Value

TV = {FCF3 × (1+g)} / {r − g} = (160 × 1.04) / (0.10 − 0.04) = 2773.3

Step 3: Discount Terminal Value

PVTV = 2773.3 / 1.103 = 2083.1

Step 4: Intrinsic Value

DCF Value = 109.1 + 115.7 + 120.1 + 2083.1 = 2428.0 crore

If the company’s market capitalization is ₹1,900 crore, the stock may be undervalued based on this simplified example of DCF.

When DCF Works Well and When It Doesn’t

DCF works well when:

• Cash flows are predictable

• Business models are stable

• Growth assumptions are reliable

• Capital structure does not fluctuate dramatically

Examples: utilities, mature tech, FMCG companies.

DCF is less reliable when:

• Cash flows are volatile

• Start-ups or early-stage businesses

• Companies undergoing restructuring

• Firms in cyclical or commodity-driven sectors

DCF is powerful, but only when assumptions reflect realistic scenarios.

DCF vs Other Valuation Approaches

Compared with these, DCF remains the most detailed method because it captures the business’s long-term earning potential.

Common Mistakes to Avoid When Using the DCF Method

• Overestimating growth rates

• Using unrealistic terminal value assumptions

• Ignoring working capital requirements

• Miscalculating WACC

• Assuming linear performance during volatile periods

• Using a short forecast period for long-cycle businesses

Accuracy improves when assumptions are conservative and grounded in business fundamentals.

Conclusion

Discounted Cash Flow is one of the most effective methods to determine a company’s intrinsic value. It helps investors cut through market noise and focus on core cash-generating potential. By learning the DCF formula, key components, and how to calculate discounted cash flow step-by-step, traders and investors can make far more informed long-term decisions.

A DCF model is not perfect, but when applied correctly, it offers one of the clearest pictures of what a business is truly worth.