DCF Valuation: What Is a Company Worth?

Valuation ratios are shortcuts. This lesson shows the long version – the calculation behind every serious company valuation. The basic idea is as old as finance itself: a business is worth the cash it will bring its owners in the future – adjusted for when that cash arrives and how certain it is.

The time value of money#

Would you rather receive $1,000 today or in ten years? Today, of course. You could invest it and have more in ten years. And a promise ten years out is less certain than cash in hand.

So future money has to be discounted to compare it with money today. The current worth of a future payment is its present value:

The higher the rate and the further away the payment, the less it’s worth today.

The DCF method#

Discounted cash flow analysis applies that idea to an entire business:

1. Forecast: estimate free cash flows for the next five to ten years.
2. Terminal value: for the years after that, assume steady, modest growth and calculate a terminal value.
3. Discount: bring all cash flows and the terminal value back to today using the discount rate, and add them up. That’s the enterprise value.
4. From enterprise value to share value: subtract net debt and divide by the number of shares – that’s fair value per share.

Try it. Change the discount rate and the perpetual growth rate in particular, and watch how strongly fair value reacts:

The discount rate#

Which rate is right? It should express the return investors demand for this company’s risk. Professionals often use the weighted average cost of capital (WACC): a blend of the interest rate on debt and the return shareholders expect. For large, stable companies typical values are 7–9%; for risky young companies far higher.

The rate also depends on the general level of interest rates. When Treasury yields rise, every company’s cost of capital rises – and present values fall. That’s why growth stocks fell so hard in 2022: their profits lie far in the future and are hit hardest by higher rates.

Terminal value#

Nobody can forecast a company’s cash flows for 50 years. So everything after the forecast period is summed up in a terminal value, usually with the Gordon growth formula:

Perpetual growth shouldn’t exceed the long-run growth of the overall economy – 1.5–3% is typical. No company can grow faster than the world it lives in forever.

Using DCF sensibly#

Because the result depends so heavily on assumptions, critics say: garbage in, garbage out. True – and yet DCF is valuable if used well:

• As a framework: it forces concrete questions. How fast can the company realistically grow? What margins are sustainable? How much must it reinvest?
• In reverse: instead of calculating fair value, ask which assumptions are baked into today’s price. If the current price requires 25% annual growth for ten years, you know how much optimism is already priced in. This is called a reverse DCF.
• With scenarios: run a pessimistic, a realistic and an optimistic case. The range is more honest than a single number.
• With a margin of safety: value investing pioneer Benjamin Graham advised buying only when the price is well below estimated value. The discount protects you from your own mistakes.

Summary#

Future money is worth less today – the more so, the higher the rate and the further away the payment. DCF adds up all discounted future free cash flows to value a business. The discount rate and terminal value dominate the result, which is why it’s so sensitive to assumptions. Used well – with scenarios, in reverse and with a margin of safety – it’s still the foundation of every serious valuation.