What it calculates

A discounted cash flow model values a business as the present value of the cash it will generate. It is the most defensible valuation method because it rests on the company's own economics rather than on what the market happens to pay for peers today.

How it is calculated

Project free cash flow for an explicit forecast horizon, then capture everything beyond it in a terminal value, usually via a perpetuity growth formula or an exit multiple. Discount each year back at the weighted average cost of capital, sum the present values, and you have enterprise value. Subtract net debt to get equity value, then divide by diluted shares for a per-share figure.

How to read the result

Look at how much of your value sits in the terminal value. If it is above roughly three quarters of the total, the model is really a bet on the terminal assumptions rather than on the forecast, and small changes to the growth rate or discount rate will swing the answer wildly. Always run the valuation across a range of both, and treat the resulting band as the output rather than any single number.

Worked example

Suppose free cash flow of 100 growing 5% a year for five years, a WACC of 9% and terminal growth of 2%. Year five cash flow is about 128. Terminal value is 128 x 1.02 / (0.09 - 0.02) = 1,865, discounted back five years to roughly 1,212. The five forecast years discount to about 434. Enterprise value is around 1,646, so the terminal value is 74% of it.

Common questions

Perpetuity growth or exit multiple for the terminal value?

Run both. Perpetuity growth is internally consistent with the rest of the model but very sensitive to the spread between the growth and discount rates. An exit multiple imports current market sentiment, which is useful as a sanity check but means your intrinsic valuation is partly a relative one.

Can terminal growth be higher than GDP growth?

Not sustainably. A company growing faster than the economy forever eventually becomes the entire economy. Most practitioners cap terminal growth at long-run inflation or nominal GDP, typically 2% to 3% in developed markets.

Should I discount at WACC or at the cost of equity?

It depends on what you are discounting. Unlevered free cash flow, which is available to all capital providers, is discounted at WACC to give enterprise value. Levered free cash flow, which is what is left after debt service, is discounted at the cost of equity and gives equity value directly.