A DCF valuation – discounted cash flow – estimates what a company is worth today by forecasting the free cash flow it will produce and discounting that back to present value. It is the most rigorous valuation method and the easiest to manipulate, because the answer is only as good as the assumptions fed in.

This guide walks a DCF end to end – the forecast, the discount rate, the terminal value – shows why it produces a range rather than a single figure, and flags the input tricks that inflate a target price.

What a DCF actually does

A DCF rests on one idea: a pound of cash next year is worth less than a pound today, so future cash must be “discounted” back to the present. The model forecasts a company’s free cash flow for several years, discounts each year to today’s value, adds them up, and arrives at an intrinsic value – what the business is worth based on the cash it will generate.

Building the forecast – revenue to free cash flow

The engine of a DCF is a multi-year forecast that turns revenue into free cash flow. Each step is an assumption an analyst must justify: a revenue growth path, an operating (EBIT) margin that may expand as the business scales, a cash tax rate applied to operating profit, depreciation added back, and capital expenditure subtracted. Get the operating leverage story right and margins widen as revenue grows; get it wrong and the whole forecast drifts.

The discount rate – small change, big swing

The discount rate, usually the weighted average cost of capital (WACC), reflects the riskiness of the cash flows and the return investors require. It is the most sensitive input in the model: shift the WACC by a single percentage point and the valuation can move dramatically, because it compounds across every future year. A suspiciously low WACC is one of the quickest ways to inflate a target price.

Terminal value – the biggest, most fragile number

A forecast cannot run forever, so a DCF estimates a terminal value for everything beyond the explicit window – and it often accounts for the majority of the total. There are two methods: a perpetuity growth rate (the cash flows grow forever at a fixed rate) or an exit multiple (applying a sale multiple in the final year).

Enterprise value to share price

The DCF produces an enterprise value – the value of the whole business. To get to what a share is worth, you subtract net debt: equity value = enterprise value − net debt, then divide by the number of shares. This is why two companies with identical operations can have very different share prices: debt sits between the business value and the shareholder.

A DCF is a range, not a point

Because small input changes swing the output so far, a single DCF number is almost meaningless. Serious analysts run a sensitivity table, varying the WACC and terminal growth rate across plausible ranges to produce a spread of values.

Illustratively, varying the WACC from 7.5% to 10.5% and the terminal growth rate from 2% to 4% might produce intrinsic values from £44 to £121 a share, with a central estimate around £54. A cross-check against comparable companies (say an EV/EBITDA range giving £52 to £80, central £67) helps triangulate. If the stock trades at £38 – below both ranges – that points to potential undervaluation, though the assumptions behind the ranges are what matter, not the headline figure.

Common DCF mistakes – how to spot a flattering model

Most manipulated DCFs share the same handful of tricks. Watch for:

• Optimistic growth – revenue or margin assumptions far above the company’s history or its peers.
• A terminal growth rate above GDP – mathematically impossible to sustain, and a large lever on the answer.
• A WACC set too low – understating risk to inflate present value.
• Ignoring capex – forecasting cash flow without the spending needed to generate it.

Any one of these can turn a fair valuation into a flattering one, so the right question about a DCF is never “what is the number?” but “what assumptions produced it?”