What Is a Discounted Cash Flow (DCF) Model?

Applying DCF analysis to equity valuation follows four broad steps.

1. Step 1

   Choose the class of DCF model

   This is equivalent to selecting a specific definition of cash flow, such as free cash flow to the firm (FCFF), free cash flow to equity (FCFE), dividends, or residual income.

   Walk me through a DCF

2. Step 2

   Forecast the cash flows

   A common approach is to forecast sales first, then derive profitability, investments, and financing from changes in sales.

3. Step 3

   Choose a discount rate methodology

   You match the discount rate to the cash flow stream: WACC for FCFF, or the required rate of return on equity (r) for FCFE and dividends.

4. Step 4

   Estimate the discount rate and discount the cash flows

   You discount the forecasted cash flows and terminal value back to present value, adjust for non-operating assets and debt if using a firm model, and divide by outstanding shares to find intrinsic value per share.

Analysts choose between three main cash flow streams in a DCF model: free cash flow, dividends, and residual income. In the 2019 survey of professional analysts, 92.8% use market multiples and 78.8% use a DCF approach when valuing individual equities. Among those who use DCF analysis, 86.9% use a discounted free cash flow model, 35.1% use a dividend discount model (DDM), and 20.5% use a residual income approach. By our calculation from those survey figures (78.8% multiplied by 86.9%), about 68.5% of all surveyed equity analysts use a discounted free cash flow model. Within that group, FCFF models are used roughly twice as frequently as FCFE models.

1. When FCF beats DDM

   Capacity to pay and control perspective

   Whereas dividends are the cash flows actually paid to stockholders, free cash flows are the cash flows available for distribution. Analysts prefer free cash flow models (FCFF or FCFE) over a DDM when the company does not pay dividends, when paid dividends differ substantially from the company's capacity to pay, when free cash flows align with profitability within a reasonable forecast period, or when the investor takes a control (majority ownership) perspective. With control comes discretion over how free cash flow is used, including changing dividends or servicing debt incurred in an acquisition.

2. FCFF

   Free Cash Flow to the Firm

   Cash flows available to all investors in the company. You discount FCFF at the weighted average cost of capital (WACC) to find firm value, then subtract the market value of debt to get equity value. It works well when a company pays no dividends, when dividends differ from capacity, when free cash flow aligns with profit, or from a control perspective.

3. FCFE

   Free Cash Flow to Equity

   Cash flows available to common stockholders after debt service and net borrowing. You discount FCFE at the required rate of return on equity (r) to find equity value directly. It fits the same ownership situations as FCFF when capital structure is stable.

4. DDM & Residual Income

   Dividend Discount Model and Residual Income

   A Dividend Discount Model (DDM) discounts distributions to shareholders authorized by the board of directors at the required rate of return on equity (r) to find stock value (V0). It is most suitable for dividend-paying stocks with a discernible dividend policy tied to profitability and a minority (non-control) perspective. Residual Income is an alternative stream of expected cash flows used to value equities when a company does not pay dividends (as an alternative to a free cash flow approach) or when free cash flow is negative.

Unlike dividends, FCFF and FCFE are not readily available data on a financial statement. You compute them from net income (NI), cash flow from operations (CFO), EBIT, or EBITDA. Earnings components such as net income, EBIT, EBITDA, and CFO should never be used directly as cash flow measures in a DCF model. These earnings measures either double-count or ignore parts of the cash flow stream. Use the exact reconciliation formulas below to calculate FCFF and FCFE. In these equations, NCC is non-cash charges, Int is interest expense, Dep is depreciation, FCInv is fixed capital investment, WCInv is working capital investment, Net borrowing is new debt issued minus debt repayments, and the after-tax interest adjustment multiplies Int by (1 − Tax rate) to reflect the tax shield.

1. FCFF from NI & CFO

   Starting from Net Income or Cash Flow from Operations

   FCFF from Net Income: FCFF = NI + NCC + After-tax interest − FCInv − WCInv. FCFF from Cash Flow from Operations: FCFF = CFO + After-tax interest − FCInv.

2. FCFF from EBIT & EBITDA

   Starting from EBIT or EBITDA

   FCFF from EBIT: FCFF = After-tax EBIT + Dep − FCInv − WCInv. FCFF from EBITDA: FCFF = After-tax EBITDA + Dep(Tax rate) − FCInv − WCInv.

3. FCFE formulas

   Computing FCFE from FCFF, Net Income, or CFO

   FCFE from FCFF: FCFE = FCFF − After-tax interest + Net borrowing. FCFE from Net Income: FCFE = NI + NCC − FCInv − WCInv + Net borrowing. FCFE from Cash Flow from Operations: FCFE = CFO − FCInv + Net borrowing.

In an FCFF model, you discount cash flows at the weighted average cost of capital (WACC). The formula is WACC = [MV(Debt) / (MV(Debt) + MV(Equity))] * After-tax rd + [MV(Equity) / (MV(Debt) + MV(Equity))] * r, where MV is market value, After-tax rd is the cost of debt rd multiplied by the tax complement, and r is the required rate of return on equity. In an FCFE model, you discount FCFE directly at r.

1. Multistage phases

   Growth, transition, and mature business phases

   Forecasting cash flows individually into the indefinite future is not generally practicable. Instead, analysts use multistage models to reflect three distinct business phases. In the growth phase, a company enjoys an abnormally high supernormal growth rate. In the transition phase, earnings and cash flow growth slows. In the mature phase, the business reaches a stable long-term equilibrium. In a two-stage model, you forecast individual cash flows from t = 1 to n, and then calculate a terminal value at time n.

2. Terminal value

   Constant-growth (Gordon growth) vs. terminal multiple

   You can find terminal value in two ways. First, you can use a constant-growth (Gordon growth) model, where Firm value at time n = FCFF(n+1) / (WACC − g), or Equity value at time n = FCFE(n+1) / (r − g), assuming the discount rate is greater than the constant growth rate g. Second, you can apply a multiple as of the terminal date. In an equity DCF or DDM, applying a P/E multiplier to forecasted EPS gives a terminal equity value.

3. Bridge to share price

   Non-operating assets, market value of debt, and diluted shares

   The full two-stage FCFF formula discounts each annual cash flow FCFFt by (1 + WACC)^t from t = 1 to n, and discounts the constant-growth terminal value back n periods by (1 + WACC)^n. Once you have the present value of operating cash flows, you segregate and value non-operating assets (such as excess cash, marketable securities, noncurrent investment securities, and nonperforming assets) separately and add them to operating asset value to find total firm value. Finally, calculate Equity value = Firm value − Market value of debt, and divide by outstanding shares to get the intrinsic value per share.

Below is an original worked example written by our team to show how the valuation formulas fit together in a live calculation. All company numbers are invented for this illustration. Suppose you are valuing Northstar Industrial at t = 0. In Year 1 (t = 1), Northstar generates Net Income (NI) of $120 million, non-cash charges (NCC) of $30 million, interest expense (Int) of $20 million, fixed capital investment (FCInv) of $40 million, and working capital investment (WCInv) of $10 million. The tax rate is 25%. WACC is 10%, and after a 2-year explicit forecast where FCFF grows 10% in Year 2, FCFF grows at a constant rate (g) of 3% forever starting in Year 3. Northstar has $50 million in excess cash (a non-operating asset), $200 million in market value of debt, and 100 million outstanding shares.

1. Step 1

   Calculate Year 1 FCFF from Net Income

   FCFF1 = 120 + 30 + 20 * (1 − 0.25) − 40 − 10 = 120 + 30 + 15 − 50 = $115.00 million.

2. Step 2

   Forecast Year 2 and Year 3 FCFF

   Growing 10% in Year 2 gives FCFF2 = 115 * 1.10 = $126.50 million. Growing at the constant rate g = 3% in Year 3 gives FCFF3 = 126.50 * 1.03 = $130.295 million.

3. Step 3

   Calculate Terminal Value at Year 2

   Dividing Year 3 FCFF by the 7% spread between the 10% WACC and the 3% constant growth rate gives TV2 = 130.295 / (0.10 − 0.03) = 130.295 / 0.07 = $1,861.36 million.

4. Step 4

   Discount cash flows to present value (t = 0) at 10% WACC

   PV(FCFF1) = 115 / 1.10 = $104.55 million. PV(FCFF2) = 126.50 / (1.10)^2 = $104.55 million. PV(TV2) = 1,861.36 / (1.10)^2 = $1,538.31 million. Total operating asset value = 104.55 + 104.55 + 1,538.31 = $1,747.41 million.

5. Step 5

   Add non-operating assets and bridge to equity value per share

   Total firm value = $1,747.41 million + $50 million excess cash = $1,797.41 million. Equity value = $1,797.41 million − $200 million market value of debt = $1,597.41 million. Divided by 100 million shares, the intrinsic value is $15.97 per share.

Once you give the standard walkthrough in an interview, your interviewer will test whether you understand how capital structure, corporate actions, and practical modeling adjustments affect the valuation output.

1. Capital structure

   Dividends, share repurchases, share issues, and leverage

   Capital structure and corporate actions are key areas of focus in free cash flow analysis. Analysts evaluate how dividends, share repurchases, share issues, and changes in leverage may affect future FCFF and FCFE. While FCFF is the cash flow available to all investors before debt service, FCFE includes net borrowing and is related to FCFF by the equation FCFE = FCFF − Int(1 − Tax rate) + Net borrowing.

2. Reverse DCF

   Reverse DCF and implied growth rates

   Instead of solving for intrinsic value V0 using an assumed growth rate, you can set V0 equal to today's market price P0 and solve the constant-growth or multistage equation for the implied growth rate g or implied required return r. Comparing that market-implied growth rate to company fundamentals shows what expectations are already priced into the stock.

Define the model, state the cash flow stream, reconcile from Net Income, discount at WACC, and bridge to per-share equity value.

1. 1

   Walk me through a DCF model and explain how you get from Net Income to intrinsic value per share.

   Show the sample answer

   Sample answer. Example answer written by our team. The applicant is invented. "A DCF model values a company as the present value of its expected future cash flows. In an unlevered DCF, I use Free Cash Flow to the Firm, which is the cash available to all investors. Starting from Net Income, I add back non-cash charges like depreciation, add back after-tax interest expense, and subtract fixed capital investments and working capital investments. I forecast those cash flows by projecting sales first and deriving profitability and investments over the explicit forecast period. Next, I calculate a terminal value at the end of the forecast period, either using the constant-growth Gordon growth formula or an exit multiple. I discount both the projected FCFF stream and the terminal value back to today using the company's weighted average cost of capital, or WACC. That gives me the value of operating assets. Finally, I add the value of any non-operating assets like excess cash to get total firm value, subtract the market value of debt to reach equity value, and divide by outstanding shares to find the intrinsic value per share."

   It defines the DCF in the first sentence, names the exact cash flow stream (FCFF), gives the complete reconciliation from Net Income including the after-tax interest adjustment, matches FCFF to WACC, and walks cleanly through non-operating assets and the debt bridge to per-share equity value.

Our team built this six-point checklist to help you audit your DCF spreadsheet or structure your spoken answer in an investment banking interview or case interview. Run through these checks to avoid the traps that cost candidates points.

1. 1. Rate match

   Cash flow and discount rate match

   If you use FCFF, discount at WACC. If you use FCFE or dividends, discount at the required return on equity (r). Never mix FCFF with r or FCFE with WACC.

2. 2. Cash flows

   No raw earnings proxies

   Confirm you did not plug Net Income, EBIT, EBITDA, or CFO directly into the discount formula without adjusting for taxes, non-cash charges, fixed capital investment, and working capital investment.

3. 3. Interest shield

   After-tax interest adjustment

   When calculating FCFF from Net Income or CFO, make sure you added back after-tax interest, not pre-tax interest.

4. 4. Terminal growth

   Terminal growth rate constraint

   In any constant-growth terminal value formula, verify that your discount rate (WACC or r) is strictly greater than your perpetual growth rate (g), and that g is comparable to or lower than the economy's nominal growth rate.

5. 5. Non-operating

   Non-operating assets segregated

   Check that excess cash, marketable securities, and noncurrent investment securities were excluded from operating cash flows and added back separately to find total firm value.

6. 6. Sensitivity

   Sensitivity analysis included

   Because Gordon growth and multistage DCF values are very sensitive to assumed growth rates and required rates of return, always test how your intrinsic value per share changes across a range of discount rate and terminal growth assumptions.