Discounted Cash Flow, Step by Step

Why this matters

Multiples compare a company's price with other prices. A discounted cash flow valuation, or DCF, estimates value directly from the business: the cash it will produce, adjusted for time and risk. It's how Buffett describes value, following John Burr Williams: the cash a business can be expected to produce over its life, discounted at an appropriate rate.¹ This lesson builds one for STU Corp, and lets you build your own.

The five steps

1. Start with free cash flow. STU Corp generated $44 million this year, after paying interest and buying equipment, as The Cash Flow Statement showed. Because it's cash available to shareholders, it's discounted at the cost of equity.
2. Forecast the next few years. Assume free cash flow grows 10% a year for five years, a little below this year's revenue growth of 14% and in line with a business that's maturing.
3. Estimate a terminal value for everything after year 5, assuming steady growth forever (next section).
4. Discount everything back to today at the 9.8% cost of equity from Cost of Capital.
5. Add it up and divide by the number of shares, 20 million, then compare with the $50 price.

The terminal value

No one can forecast year by year forever. Instead, a DCF assumes that after the forecast years, cash flow grows at a steady, modest rate indefinitely, and values all of it with one formula:

Terminal value = Next year's free cash flow ÷ (Discount rate − Long-run growth rate)

The terminal value is calculated as of the end of year 5, so it's discounted back five years like the rest. The long-run growth rate has to stay modest, because no company can outgrow the whole economy forever. For a sense of scale, the Federal Reserve's September 2026 projections put longer-run US growth at about 2% a year after inflation, with inflation of about 2%: roughly 4% a year in total.² This valuation uses 3%.

$ millions	Free cash flow	Discount factor at 9.8%	Value today
Year 1	48.4	0.911	44.1
Year 2	53.2	0.829	44.2
Year 3	58.6	0.755	44.2
Year 4	64.4	0.688	44.3
Year 5	70.9	0.627	44.4
Terminal value: 70.9 × 1.03 ÷ (0.098 − 0.03)	1,073.4	0.627	672.6
Total value of the shares			893.8
Per share: 893.8 ÷ 20 million			$44.69

The estimate is about $44.69 a share, roughly 11% below the $50 price. Notice where the value comes from: about three quarters of it is the terminal value, the years after year 5. That's typical, and it's why the next lesson focuses on it.

Working backward: what does the price assume?

Instead of asking what STU Corp is worth, you can ask what the $50 price assumes. Keeping the other assumptions the same, the price makes sense if free cash flow grows about 12.8% a year for five years, or if investors are content with about a 9.1% return instead of 9.8%. That turns the valuation into a question you can research: is 12.8% growth realistic, given STU Corp's subscriptions, its biggest customer, and its expiring patent?

Try it yourself

Change the assumptions below. Try raising the growth rate by two points, then try raising the discount rate by one point instead, and compare how far each moves the value.

Key takeaways

• A DCF forecasts free cash flow, adds a terminal value, discounts everything to today, and divides by the shares.
• Terminal value = next year's cash flow ÷ (discount rate − long-run growth). Keep long-run growth modest.
• STU Corp's base case is about $44.69 a share, with about three quarters of the value from the terminal value.
• Working backward shows what the price assumes: about 12.8% yearly growth for five years.

Check your understanding

Next year's free cash flow is expected to be $50 million, the discount rate is 9%, and long-run growth is 4%. What's the terminal value?

1. $555 million
2. $1,000 million
3. $1,250 million

Why must the long-run growth rate in a DCF stay well below the discount rate?

1. Because a company's growth slows to zero once the five-year forecast ends, so any long-run rate is optimistic.
2. Because the SEC requires DCF models in company filings to use conservative growth assumptions.
3. As growth nears the discount rate, the terminal value soars toward infinity, and no company outgrows the economy forever.

What's next

Most of STU Corp's value came from the terminal value. The next lesson, Terminal Value and Sensitivity, shows how much the answer moves when its assumptions change.