A Discounted Cash Flow (DCF) valuation is the most theoretically defensible way to value a business — and also the most abused. Done well, it tells you what a company is worth based on the cash it will generate, discounted back to today's dollars. Done badly, it's an Excel mirage where junior analysts torture the discount rate until the answer matches what the banker wants.
This guide walks through the DCF properly, in seven concrete steps, with a worked SaaS example at the end. Whether you're valuing a target for acquisition, defending a fundraising valuation, or just trying to understand what your own business is worth — this is the framework professionals actually use.
What DCF Really Measures (and What It Doesn't)
A DCF measures the present value of the free cash flows a business will generate over its life. That's it. Not the price someone will pay for it. Not the multiple of EBITDA the market is paying right now. Not the strategic synergy a specific buyer might unlock.
DCF answers a single question: "if the cash flows in my forecast are right, what is this business worth today?"
That makes it powerful when your forecast is defensible, and dangerous when it isn't. Most DCF errors aren't math errors — they're forecast errors dressed up in math.
Step 1: Forecast Free Cash Flow
DCF doesn't discount accounting profit. It discounts Unlevered Free Cash Flow (UFCF) — the cash a business generates before any decision about how to finance it.
Unlevered FCF formula
UFCF = EBIT × (1 − Tax Rate) + Depreciation & Amortisation − CAPEX − Change in Working Capital
A few clarifications that trip up first-timers:
• EBIT, not EBITDA. You tax-effect EBIT, then add back D&A.
• Tax rate should be marginal cash tax rate, not effective book rate.
• CAPEX includes both maintenance and growth CAPEX.
• Change in working capital: an INCREASE in WC is a USE of cash (subtract).
Forecasting revenue and margins
Five years of explicit forecast is standard, ten years for growth companies whose cash flows are still ramping. Beyond that, you're inventing — and the terminal value (Step 3) is doing the work.
Build revenue bottom-up where you can: # customers × ARPU × retention, or units sold × price × growth. Top-down ("we'll capture 3% of a $20bn TAM") is fine for a sanity check but should never be your primary build.
Margins should compress as the company matures, not expand. Anyone forecasting EBITDA margin growing from 18% to 38% over five years is either modelling a once-in-a-decade outlier or fooling themselves.
CAPEX and working capital changes
For asset-light businesses (SaaS, services), CAPEX is small — typically 2–5% of revenue. For asset-heavy (manufacturing, hospitality, telecom), CAPEX can run 15–25% of revenue and dominate the cash flow.
Working capital changes scale roughly with revenue growth. A useful shortcut: ΔWC ≈ (DSO + DIO − DPO) / 365 × ΔRevenue.
Step 2: Pick a Discount Rate (WACC)
The discount rate is what makes future dollars worth less than today's. Get it wrong by 1% and your valuation can swing 15–25%. Get it wrong by 3% and you might as well roll dice.
For most DCFs, the right discount rate is the Weighted Average Cost of Capital (WACC) — the blended return required by both equity and debt investors:
WACC = (E/V × Re) + (D/V × Rd × (1 − T))
Cost of equity (CAPM)
Re = Rf + β × (Rm − Rf). Risk-free rate is the 10-year Treasury yield. Equity risk premium is currently ~5.5%. Beta comes from comparable public companies ("comparable" means same sector, similar size, similar capital structure).
Cost of debt
Yield to maturity on the company's existing debt, after-tax. For private companies, use the yield on bonds of public peers with similar credit profiles, or simply add a 200–400 bp spread over the 10-year Treasury.
Weighted average
Use target capital structure, not today's snapshot. A startup with 100% equity today won't stay that way forever — most companies converge to 20–40% debt over time.
For a typical mid-cap, WACC lands in the 8–12% range. For early-stage growth companies, 12–18%. We cover the full mechanics in our WACC Explained post.
Step 3: Calculate Terminal Value
Here's an uncomfortable truth: in most DCFs, 60–80% of the total enterprise value comes from the terminal value — the lump-sum estimate of cash flows beyond your explicit forecast period. Which means your DCF is, mathematically, mostly an opinion about the long-run steady state.
Two methods. Use both. Reconcile them.
Gordon Growth Method
TV = FCF (final year) × (1 + g) / (WACC − g)
Where g is the perpetual growth rate. Never use a g higher than the long-run GDP growth of the country the business operates in (typically 2–3% for developed economies). A g of 5% implies the company grows faster than the entire economy forever, which is impossible.
Exit Multiple Method
TV = Final-year EBITDA × Exit Multiple
Cleaner, more market-grounded. Use the median EV/EBITDA multiple of comparable public companies, adjusted downward 10–20% for the fact that you're forecasting steady-state (no growth premium).
Calculate both. The implied growth rate from your Exit Multiple should be reasonable (1–4%). The implied exit multiple from your Gordon Growth should match peer comps. If they wildly disagree, one of your inputs is wrong.
Step 4: Discount Everything Back
Now discount every forecast year's FCF — and the terminal value — back to today using WACC.
PV(Year n) = FCF(n) / (1 + WACC)^n
By convention, use the mid-year discounting convention: discount Year n's FCF at (n − 0.5), reflecting the fact that cash arrives throughout the year, not all on December 31. It bumps your valuation by ~3–5%.
Sum every PV plus the discounted terminal value. That sum is Enterprise Value (EV).
Step 5: Bridge From Enterprise to Equity Value
Enterprise Value is the value of the whole business. Equity Value is what's left for shareholders after the debt-holders are paid. The bridge:
Equity Value = Enterprise Value − Net Debt − Preferred Equity − Minority Interest + Cash & Cash Equivalents
Net Debt is total debt minus cash. (Yes, cash gets added back — it's already in your hand.) Per-share equity value = Equity Value / Diluted Shares Outstanding.
Step 6: Sensitivity Analysis
A single-point DCF answer is misleading. Always present a sensitivity table — typically a 2×2 grid of WACC × terminal growth rate, with the resulting EV in each cell. This shows the reasonable range of value, not a false-precision single number.
Bankers present this as a football field chart — a horizontal bar chart with the DCF range next to other valuation methods (comps, precedent transactions, LBO). The overlap zone is where the realistic price sits. We cover football fields in detail in a separate post.
Step 7: Sanity-Check Against Comps
If your DCF says the company is worth a 25× EV/EBITDA multiple and comparable public companies trade at 8×, something is wrong with your DCF. Either your growth assumptions are too aggressive, your WACC is too low, or your terminal value is doing too much work.
DCF should anchor on intrinsic value. Comps should anchor on market reality. The two methods are most useful when they disagree slightly — that gap is where the interesting conversation lives.
Worked Example: Valuing a SaaS Company
Cloudifyr Inc. is a $20M ARR vertical-SaaS business. We forecast 5 years of free cash flow, apply WACC of 11%, terminal growth of 2.5%, and arrive at an enterprise value of ~$185M — a 9.3× revenue multiple, well within the public-comp range for vertical SaaS of this scale.
Inputs: revenue grows 40% → 30% → 22% → 16% → 12%; EBITDA margin expands from 14% to 24% as the business matures; CAPEX is 3% of revenue; working capital is roughly neutral. Terminal value is $310M (Gordon Growth) / $295M (Exit Multiple at 13× EBITDA) — the two methods are within 5%, which is exactly what you want.
WACC build: risk-free rate 4.4%, equity risk premium 5.5%, beta 1.3, cost of equity 11.6%. Cost of debt 7% after-tax. 80% equity / 20% debt → blended WACC of 10.7%, rounded to 11%.
Sensitivity: WACC ranges 9.5%–12.5%, terminal growth 2.0%–3.0%, producing an EV range of ~$165M to ~$215M. That's the football field for the DCF; we'd cross-reference with public SaaS comps (8×–11× revenue today) and recent precedent transactions.
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FAQ
What's the difference between DCF and NPV?
NPV (Net Present Value) is the math; DCF is the application of that math to value an entire business. NPV is also used to evaluate individual projects (capex decisions, M&A bids). The mechanics are identical.
How many years should I forecast in a DCF?
Five years is standard for mature businesses, ten years for high-growth companies whose cash flows haven't normalised. Beyond ten years, your forecast is essentially noise — the terminal value should absorb it.
Should I use unlevered or levered free cash flow?
For enterprise value, use unlevered (UFCF) and discount at WACC. For equity value directly, use levered FCF and discount at cost of equity. Most professionals use unlevered → bridge to equity, because comparable analysis is easier on EV.
My DCF gives a very different answer than my comps analysis. Which do I trust?
Both, simultaneously. DCF anchors intrinsic value; comps anchor market reality. If they disagree by less than 20%, you're in healthy tension. If they disagree by 50%+, one method has a flawed input — usually your DCF growth or terminal value assumptions.