DCF Valuation: How to Calculate What a Stock Is Really Worth

Imagine you own a business that generates $100,000 in profit this year. An investor offers you $1 million for it. Do you sell? Most people would. But what if that $100,000 grows steadily for the next decade? What if it grows for 30 years? Suddenly, the answer becomes harder—and that difficulty is precisely why DCF valuation exists.

DCF (discounted cash flow) valuation is the most rigorous framework on Wall Street for determining what a stock should theoretically cost. Rather than relying on what the market pays today, DCF works backward from the company's future cash generation to calculate its intrinsic value. When a stock trades below that value, it's potentially undervalued. When it trades above, it's potentially overvalued.

For equity investors—especially value-oriented ones—understanding DCF isn't optional. It's the difference between making decisions based on price charts and making them based on fundamental math.

What is DCF Valuation and Why It Matters

DCF valuation is built on a simple principle: a dollar you receive next year is worth less than a dollar today, because you could invest that dollar today and earn returns. DCF translates all of a company's future cash flows into present-day value, giving you a single number that represents what the business is worth now.

This matters because market price and intrinsic value diverge constantly. In March 2020, airlines like Southwest (LUV) crashed 60% in weeks as pandemic fears gripped markets—but their underlying businesses hadn't deteriorated that much. The stock had become cheaper relative to its long-term cash-generation potential. Conversely, in early 2021, Tesla (TSLA) traded at 180x trailing earnings. The market was pricing in growth and profitability improvements that may have been unrealistic at that valuation.

DCF gives you a framework to answer: Is this price justified by what the business will actually earn?

Why Companies Choose DCF Over Other Methods

Investment firms, hedge funds, and serious equity analysts use DCF because it's theoretically sound and transparent. Unlike relative valuation methods (comparing a stock's P/E ratio to peers), DCF doesn't depend on what the market thinks other companies are worth. It depends only on the company's own cash flows and the investor's assessment of risk.

This independence from market sentiment is both a strength and a weakness. It means DCF can identify mispricings. It also means you have to be right about the company's future—and that's harder than it sounds.

The Core DCF Formula and Its Components

Understanding the DCF Equation

At its heart, DCF is straightforward:

Intrinsic Value = (PV of Projected Cash Flows) + (PV of Terminal Value)

Where PV = Present Value, calculated by dividing each year's cash flow by (1 + discount rate)^number of years

The formula asks: What are all the cash flows this company will generate, adjusted for the time value of money? That number is your valuation floor.

Three Critical Inputs You Must Get Right

Get any one of these wrong, and your valuation can be off by 50% or more. That's not a flaw of DCF—it's a feature. It forces you to think carefully about what you actually believe about the business.

Building Your Forecast: Free Cash Flow Projections

What Is Free Cash Flow and Why It Matters in DCF

Free cash flow (FCF) is the cash a company generates from operations after paying for capital expenditures and working capital. Unlike earnings, which can be manipulated through accounting choices, FCF is harder to fake. A company can report high net income but have negative free cash flow if it's spending heavily on equipment or inventory.

For DCF, you use FCF because it represents real cash available to investors (after the company has reinvested in itself).

Free Cash Flow = Operating Cash Flow − Capital Expenditures

You can also calculate it from net income: Net Income + Depreciation/Amortization − Changes in Working Capital − Capital Expenditures

Projecting 5-10 Years of Cash Flows

Most DCF models project cash flows explicitly for 5-10 years. You start with historical cash flow data, analyze what's driven growth or decline, and project forward based on your view of the company's competitive position and industry trends.

Example: Microsoft (MSFT) 2023-2024

Suppose you're building a DCF for Microsoft in early 2024. You'd examine:

• Historical FCF: MSFT generated approximately $82 billion in FCF in fiscal 2023
• Growth drivers: Cloud revenue (Azure) growing 30%+, AI adoption accelerating, enterprise spending stable
• Your projection: 8-12% FCF growth over 5 years, moderating to 3-4% thereafter as the company matures
• Year 1 FCF forecast: $82B × 1.10 = $90.2B (10% growth)
• Year 2 FCF forecast: $90.2B × 1.10 = $99.2B
• And so on through Year 5 or 10

The key is being realistic. If Microsoft has grown FCF at 8% historically, assuming 20% growth without a major strategic shift is self-deception.

Building Realistic Growth Assumptions

Optimism is the enemy of good DCF analysis. Most individual investors overestimate growth rates, leading to inflated valuations. Before you project 15% growth, ask:

• What's the company's historical growth rate? (Usually found in annual reports or Yahoo Finance)
• Is there a structural reason growth will accelerate? New markets, new products, industry tailwinds—or is growth already reflected in current revenue?
• What would need to happen for that growth rate to hold? If you're projecting 20% growth for a $300B revenue company, you're assuming that company will more than double in 5 years. Is that realistic?
• What are competitors doing? If your company is gaining share, what's the source? Market growth, stolen share, or price increases? Only the first two are sustainable long-term.

As a rule of thumb: mature, profitable companies rarely sustain more than 5-8% real FCF growth indefinitely. High-growth companies (software, biotech) might grow at 15-25% for 5-10 years before moderating. Cyclical businesses require you to think about where they are in the cycle.

Calculating Terminal Value and Discount Rates

The Terminal Value Problem

Terminal value represents all cash flows the company will generate beyond your explicit forecast period (typically years 6-10). For most mature companies, this accounts for 60-80% of the total DCF valuation. That makes it both critically important and wildly uncertain.

There are two methods to calculate terminal value:

Method 1: Perpetuity Growth Method

Terminal Value = Year 10 FCF × (1 + g) / (Discount Rate − g)

Where g is the perpetual growth rate you assume for the company's remaining life. For most companies, this is 2-3%—roughly in line with long-term GDP growth. For declining businesses, it might be 0-1%. For no-growth scenarios, you use a simpler formula: FCF / Discount Rate.

Example: If Microsoft's Year 10 FCF is projected at $180 billion, your discount rate is 8%, and you assume 2.5% perpetual growth:

Terminal Value = $180B × (1.025) / (0.08 − 0.025) = $180B × 1.025 / 0.055 = $3.36 trillion

That sounds absurd because it is—it's the value of a business that will generate cash forever. This is why you discount it back to today (dividing by the discount rate raised to the power of 10).

Method 2: Exit Multiple Method

Alternatively, you can estimate what multiple of EBITDA or FCF the company might trade at in 10 years, then multiply by projected Year 10 EBITDA or FCF. This anchors terminal value to market reality rather than pure assumptions about perpetual growth.

Example: If you believe Microsoft will trade at 20x FCF in 2034 (based on historical and peer multiples), and Year 10 FCF is $180B:

Terminal Value = $180B × 20 = $3.6 trillion

The two methods usually yield similar results if your assumptions are internally consistent. If they diverge wildly, it's a red flag to reconsider your assumptions.

Understanding the Discount Rate (WACC)

The discount rate reflects two things: the risk-free rate (what you could earn in Treasury bonds) and the company's additional risk premium (equity risk premium). Together, they represent your required return to invest in this stock instead of a safer alternative.

The most common approach is calculating the Weighted Average Cost of Capital (WACC):

WACC = (E/V × Cost of Equity) + (D/V × Cost of Debt × (1 − Tax Rate))

Where E = market value of equity, D = market value of debt, V = E + D

This is getting into the weeds, so here's the practical version: most mature, profitable companies have a WACC of 6-10%. High-growth tech companies or risky startups might be 12-18%. Utilities and bonds are lower, around 5-7%.

The point: a lower discount rate makes the business seem more valuable (lower risk). A higher discount rate makes it seem less valuable (higher risk). The difference between 7% and 9% WACC can swing a DCF valuation by 20-30%.

Working Through a Real DCF Example: Coca-Cola (KO)

The Setup

Let's build a simplified DCF for Coca-Cola as of late 2023. KO is a mature beverage company with stable cash flows, moderate growth, and consistent dividend payments—an ideal DCF candidate.

Step 1: Historical Financials and Baseline

• FCF (2023): ~$11.5 billion
• Historical 5-year FCF growth: ~4-5% annually
• Current debt: ~$35 billion; current equity market cap: ~$270 billion
• Cost of equity (using CAPM): ~7.5%
• After-tax cost of debt: ~2.5%
• WACC: approximately 6.5%

Step 2: Project 5-Year FCF

Step 3: Calculate Terminal Value

Using the perpetuity growth method:

• Year 5 FCF: $14.18B
• Perpetual growth rate: 2.5% (slightly above long-term GDP growth, reflecting KO's pricing power)
• Terminal Value = $14.18B × (1.025) / (0.065 − 0.025) = $14.18B × 1.025 / 0.04 = $363.1B
• Discount back 5 years: $363.1B × 0.733 = $266.2B (present value of terminal value)

Step 4: Calculate Intrinsic Value Per Share

• PV of 5-year FCF: $54.25B
• PV of terminal value: $266.2B
• Enterprise Value: $54.25B + $266.2B = $320.45B
• Less: Net debt (~$24B): $320.45B − $24B = $296.45B (equity value)
• Shares outstanding: ~2.62 billion
• Intrinsic value per share: $296.45B / 2.62B = $113.20 per share

If KO was trading at $110 in late 2023, the model suggests the stock is fairly valued or slightly undervalued. A 5-7% margin of safety would suggest an attractive entry around $103-$105.

The Critical Role of Sensitivity Analysis

Why One DCF Number Isn't Enough

The intrinsic value of $113.20 from our Coca-Cola example is not a prediction. It's a single point estimate based on specific assumptions that you should be uncertain about. What if growth is 3% instead of 4%? What if the discount rate should be 7% instead of 6.5%? These modest tweaks swing the valuation significantly.

This is why professionals build sensitivity tables—grids that show how valuation changes across different assumption combinations.

Example Sensitivity Table: Coca-Cola

Notice that changing the perpetual growth rate from 2.5% to 3.0% (half a percentage point) raises intrinsic value from $113.20 to $123.54—nearly a 9% increase. Changing WACC from 6.5% to 7.0% drops it from $113.20 to $104.12—also about 8%. This illustrates the massive sensitivity of DCF to small input changes.

Building Your Own Sensitivity Analysis

Always do this before making an investment decision. If your base case intrinsic value is $100, but the sensitivity table shows that reasonable variations in your assumptions produce values ranging from $65 to $145, you need a wider margin of safety. You should buy only if the stock trades at $60 or less, not at $85.

DCF Valuation: Common Mistakes and How to Avoid Them

Mistake 1: Forecasting Growth Like an Optimist, Not an Analyst

The most common error: assuming a company will grow faster than its historical rate without a clear catalyst. Many investors project 10-15% growth for mature companies with 3-4% historical growth. There's no mechanism for the acceleration. There's just wishful thinking.

How to avoid it: Use historical growth as your baseline. If you're assuming acceleration, it should be because of a specific, structural change: a new market, major product launch, or industry disruption. And even then, be conservative. Market share gains are usually temporary.

Mistake 2: Ignoring Competitive Dynamics

Your 5-year cash flow projection assumes the company maintains its current margins and market share. But what if a competitor enters, undercuts on price, or steals share? Amazon's entry into a new category has repeatedly compressed margins for incumbents.

How to avoid it: Ask: Why should this company's competitive position remain unchanged? What's the moat? Patent protection? Brand power? Network effects? Switching costs? If you can't articulate a clear competitive advantage that will persist, assume gradual margin compression or market share loss.

Mistake 3: Using a Discount Rate That Doesn't Match Risk

Using a 6% WACC for a biotech company in early clinical trials massively overvalues risk. Using 15% for Microsoft massively undervalues its stability. The discount rate should reflect the company's actual business risk, financial leverage, and uncertainty around your projections.

How to avoid it: Don't just use an industry average. Calculate WACC using the company's actual debt, equity, and costs of capital. Use the sensitivity table to see how much the valuation changes if WACC is 1-2% higher or lower. If you're highly uncertain about the business's future, use a higher discount rate. If it's very stable (utilities, blue-chip dividend payers), use a lower one.

Mistake 4: Terminal Value Taking Over the Model

If terminal value represents 85% of your enterprise value and your intrinsic value is $100, you're effectively betting on perpetual cash flows decades into the future. That's a risky bet, and it requires very conservative terminal growth assumptions (1-2%, not 4-5%).

How to avoid it: Extend your explicit forecast period if terminal value is creeping above 75% of total value. Or lower your terminal growth rate. Most mature companies should use 2-3% perpetual growth. High-growth companies should still revert to 3-4% by the end of the explicit forecast period, not assume 15% perpetuity.

Mistake 5: Building a Model You Don't Understand

Some investors download Excel templates or use online DCF calculators without understanding how the assumptions change the output. They plug in numbers, get an answer, and feel confident. That's dangerous.

How to avoid it: Build your model from scratch or thoroughly stress-test someone else's. Know what each input does. Understand the sensitivity table. If you can't explain why you chose a 7% WACC or 4% perpetual growth, you shouldn't rely on the output.

When DCF Works Best (and When It Doesn't)

Strong Use Cases for DCF

• Mature, profitable, stable-cash-flow businesses: Microsoft, Coca-Cola, Johnson & Johnson. These companies have predictable earnings and cash flows, making your forecast more reliable.
• Dividend-paying utilities and REITs: Electric utilities and real estate investment trusts have stable, regulated cash flows. DCF can value them reliably.
• Leveraged buyout candidates: Private equity firms use DCF to determine acquisition prices for stable businesses. It's ideal for that analysis.
• Activist investing or spinoff scenarios: When you're trying to determine if a parent company is undervaluing a subsidiary, DCF can separate the pieces.

Weak Use Cases for DCF

• Early-stage growth companies: If a company's revenue is growing 50%+ annually, small changes to growth rate assumptions create absurdly large valuation swings. Better to use revenue multiple or comparable company analysis.
• Highly cyclical industries: Auto manufacturers, semiconductor makers, and construction companies have earnings that swing with cycles. Where in the cycle are you? Your DCF answer depends entirely on that, which undermines precision.
• Unprofitable or cash-burn startups: If a company doesn't yet have positive free cash flow and won't for 5+ years, you're essentially guessing when profitability happens and what margins will be. That's not analysis; it's science fiction.
• Companies facing existential threats: If the business model is under pressure from disruption (traditional media facing digital competition), your long-term assumptions are likely wrong.

DCF as One Tool Among Many

Combining DCF With Other Valuation Methods

Professional analysts don't rely on DCF alone. They triangulate using multiple approaches:

• Comparable company multiples: What are peers trading at P/E, EV/EBITDA, or price-to-FCF? If your DCF says the stock is worth $100 but identical peers trade at 15x earnings and this company earns $6 per share, the market thinks it's worth $90. The gap is worth investigating.
• Precedent transactions: When similar companies have been acquired, at what multiples? This grounds your valuation in market reality.
• Sum-of-the-parts analysis: For conglomerates, value each business segment separately using appropriate methods, then add them up.
• Asset-based valuation: For asset-heavy businesses (real estate, manufacturing), intrinsic value is partly grounded in net asset value.

If your DCF intrinsic value is $100 and comparable company multiples suggest $95, but the stock trades at $75, that's a stronger signal to buy than DCF alone giving you $100.

Practical Next Steps: Building Your First DCF

The Do-It-Yourself Approach

Step 1: Choose your stock carefully. Start with mature, stable, profitable companies: consumer staples, healthcare leaders, tech giants with established business models. Avoid unprofitable or highly cyclical companies on your first attempt.

Step 2: Gather historical financials. Use company 10-K filings (SEC.gov), Yahoo Finance, or GuruFocus. You need 5 years of free cash flow history and current balance sheet information.

Step 3: Build your forecast. Project 5-10 years of FCF using your assumptions about revenue growth and capital intensity. Write down your reasoning. Be conservative.

Step 4: Calculate WACC. You can use simplified estimates: cost of equity around 7-9% for large-cap stocks, cost of debt based on current interest rates and the company's credit rating, and the weights based on the company's capital structure.

Step 5: Calculate terminal value. Use 2-3% perpetual growth for mature companies. Discount it back.

Step 6: Build your sensitivity table. Show how the valuation changes across 2% ranges in discount rate and terminal growth assumptions. This is where you discover if your thesis is robust or fragile.

Step 7: Compare to market price. What margin of safety do you want before investing? 20%? 30%? Only buy if the stock offers that margin.

Tools to Use

• Excel or Google Sheets: Build your own model from scratch. You'll learn more than using templates, and you'll understand every number.
• Seeking Alpha Premium or Morningstar: These platforms provide analyst estimates and forward-looking consensus cash flow projections to sanity-check yours.
• CapitalIQ or Bloomberg Terminal: If you have access (usually institutional investors), these have superior historical data and modeling tools. Most individual investors don't need this.

Key Takeaways: What You Now Know About DCF

• DCF valuation calculates intrinsic value by discounting a company's projected future free cash flows to present-day dollars, accounting for the time value of money and risk.
• The three critical inputs—projected free cash flows, terminal value, and discount rate—require careful judgment. Small changes in any of them swing valuation by 10-30%.
• Avoid optimism bias when forecasting growth. Historical rates are usually a better guide than projected acceleration, unless you can point to a specific catalyst.
• Terminal value typically accounts for 60-80% of total valuation, making it wildly important and wildly uncertain. Use conservative perpetual growth assumptions (2-3% for mature companies).
• Always build a sensitivity table showing how valuation changes across different discount rates and growth assumptions. Your goal isn't a single number but an intrinsic value range.
• DCF works best for mature, stable, cash-generative businesses. It's unreliable for unprofitable startups, highly cyclical companies, or businesses facing disruption.

With Your DCF Analysis

DCF valuation is a learnable skill, but it requires practice. Your first model will probably be less precise than your tenth. That's normal. The goal isn't perfect prediction—the future is inherently uncertain. The goal is disciplined thinking about what a company is worth based on what it will earn.

Start with a company you know well and a stable business model. Walk through the forecast, terminal value, and discount rate logic. Build your sensitivity table. Then compare your intrinsic value to the current market price. The gap between the two is where opportunity lives.

This article is part of Ticker Daily's comprehensive Fundamental Analysis guide, which covers valuation, profitability analysis, balance sheet evaluation, and competitive advantage assessment. DCF is one tool in that toolkit. Master it, but don't let it be your only tool.