Lesson 77 - Intermediate Accounting Course 

77. Discounted Cash Flow (DCF) Valuation: Step-by-Step Guide

Discounted Cash Flow (DCF) valuation is one of the most widely used methods to estimate the value of a business or investment based on its expected future cash flows.

DCF calculates the present value of projected future cash flows by discounting them back to today’s value using a required rate of return.

1️⃣ Why Use DCF?

DCF is useful because:
✔️ It considers the time value of money (a dollar today is worth more than a dollar in the future).
✔️ It provides a detailed, fundamental valuation of an asset or company.
✔️ It helps in making investment decisions (e.g., stock valuation, M&A analysis, capital projects).

2️⃣ The Formula for DCF 

If there is a terminal value (TV) (for companies expected to operate indefinitely), we add:

Where:

• g = Long-term growth rate
  
  

• TV = Terminal value (estimates future value beyond forecast period)
  
  

• n = Number of forecasted years

3️⃣ Step-by-Step DCF Calculation

Step 1: Forecast Future Free Cash Flows (FCF)

• Estimate future revenue growth
  
  

• Subtract operating costs, taxes, and capital expenditures
  
  

• Use 5 to 10 years of projected cash flows
  
  

📌 Example:

Step 2: Choose a Discount Rate

The discount rate is usually the Weighted Average Cost of Capital (WACC), calculated as:

WACC= (E/V) × Re + (D/V) × Rd × (1−Tc) 

Where:

• E = Equity value
  
  

• D = Debt value
  
  

• V=E+D  (Total value)
  
  

• Re = Cost of equity
  
  

• Rd = Cost of debt
  
  

• Tc = Tax rate
  
  

Example: If WACC = 10%, we will discount cash flows using 10%.

Step 3: Calculate Present Value of Cash Flows

Use the DCF formula to discount each year’s cash flow.

Step 4: Estimate Terminal Value

Use either:

1. Gordon Growth Model

or
2. Exit Multiple Method

Step 5: Sum the Present Values

Final DCF value = Sum of discounted FCFs + Discounted terminal value

If valuing equity, subtract debt and add cash.

4️⃣ Pros and Cons of DCF

✅ Pros
✔️ Based on fundamentals, not market trends
✔️ Accounts for time value of money
✔️ Flexible – can apply to any asset

❌ Cons
✖️ Highly sensitive to assumptions (growth rate, WACC)
✖️ Difficult to predict long-term cash flows accurately

5️⃣ When to Use DCF?

✔️ Valuing stocks (e.g., Amazon, Tesla)
✔️ Mergers & Acquisitions (M&A)
✔️ Project investment decisions