DCF Analysis
Discounting unlevered free cash flows to determine intrinsic value
~25 min read
A discounted cash flow (DCF) analysis values a business based on the present value of its future cash flows. The core logic is simple: a dollar received in the future is worth less than a dollar today because of the time value of money and investment risk. A DCF projects the cash flows a business will generate over a forecast period (typically five years), estimates a terminal value for all cash flows beyond that horizon, and then discounts everything back to today at a rate that reflects the riskiness of those cash flows.
Of all the valuation methods, DCF is the most theoretically rigorous. It does not depend on what the market happens to be paying for similar companies (as comps do) or what acquirers paid in past deals (as precedent transactions do). Instead, it asks a fundamental question: what is this business intrinsically worth based on the cash it will produce? That theoretical purity comes with a practical tradeoff: DCF is extremely sensitive to assumptions about growth, margins, and discount rates. Small changes in inputs can swing the output by 20-30%.
Unlevered Free Cash Flow (UFCF)
The DCF model projects unlevered free cash flow, which represents cash available to all capital providers (debt and equity) before any financing costs. UFCF is calculated as:
- Start with EBIT (operating income)
- Subtract taxes on EBIT (using the marginal tax rate, not actual taxes paid, because we are ignoring the tax shield from debt)
- Add back depreciation and amortization (non-cash charges)
- Subtract capital expenditures (cash spent on maintaining and growing assets)
- Subtract (or add) changes in net working capital (increases in working capital consume cash; decreases release cash)
The result is the cash the business generates from operations, independent of how it is financed. Using unlevered cash flows is essential because the discount rate (WACC) already accounts for the cost of both debt and equity. If you used levered cash flows (after interest), you would be double-counting the cost of debt.
Weighted Average Cost of Capital (WACC)
WACC blends the cost of equity and the after-tax cost of debt, weighted by their proportions in the company's capital structure. E is the market value of equity, D is the market value of debt, and the tax rate reflects the deductibility of interest expense. The cost of equity is typically estimated using the Capital Asset Pricing Model (CAPM): Cost of Equity = Risk-Free Rate + Beta x Equity Risk Premium. The cost of debt is the yield on the company's outstanding debt or the rate it would pay on new borrowings. WACC for most companies falls in the 8-12% range, though it varies by industry, leverage, and market conditions.
| Gordon Growth Method | Exit Multiple Method | |
|---|---|---|
| Approach | Assumes cash flows grow at a constant rate forever beyond the projection period | Assumes the business is sold at a market multiple of its final-year EBITDA or FCF |
| Formula | TV = Final Year FCF x (1 + g) / (WACC - g) | TV = Final Year EBITDA x Exit Multiple |
| Key assumption | Terminal growth rate (g), typically 2-3% (roughly GDP growth) | Exit multiple, typically drawn from current trading comps |
| Strength | Purely intrinsic; does not rely on market multiples | Grounded in observable market data; easier to defend |
| Weakness | Extremely sensitive to the growth rate assumption; small changes in g have outsized impact | Introduces market-based pricing into a supposedly intrinsic method |
| Typical use | Academic models, investment banking presentations | PE models (preferred because it aligns with how sponsors think about exits) |
DCF Enterprise Value
Each year's unlevered free cash flow is divided by (1 + WACC) raised to the power of that year's number, converting future dollars into present-value dollars. The terminal value (whether calculated via Gordon Growth or Exit Multiple) captures all value beyond the forecast period and is also discounted back. In most DCF analyses, the terminal value accounts for 60-80% of total enterprise value, which is why the terminal value assumptions matter so much. After summing all discounted cash flows and the discounted terminal value, the result is the implied enterprise value. Subtract net debt to arrive at equity value.
Sensitivity and Why PE Uses DCF Less Than Bankers
The biggest practical problem with DCF is its sensitivity to two inputs: the discount rate (WACC) and the terminal growth rate or exit multiple. A 1-percentage-point change in WACC can shift the implied enterprise value by 10-15%. A half-point change in terminal growth rate can move it by a similar amount. Because these inputs require judgment, two analysts can build a DCF on the same company and arrive at valuations that differ by 30% or more.
This is why PE firms tend to rely on DCF less than investment bankers do. Bankers use DCF extensively in fairness opinions and pitch books because its theoretical rigor provides legal and analytical cover. PE firms, however, are making actual investment decisions with their own capital. They prefer methods that are more directly tied to how they generate returns:
- LBO analysis tells a PE firm exactly what it can afford to pay at a given debt level and target return. It is the most actionable valuation tool for a financial buyer.
- Trading comps and precedent transactions anchor pricing to what the market and other buyers actually pay, which is more relevant for winning a deal than a theoretical intrinsic value.
That said, DCF is not ignored. Many PE firms include a DCF as a sanity check, and it is especially useful for businesses with long-duration, predictable cash flows (infrastructure, utilities, contracted revenue businesses) where the projection assumptions are more reliable.
Simplified DCF for an Industrial Distributor
A PE firm is evaluating a specialty industrial distributor generating $60M in EBITDA. The team builds a five-year DCF:
- Year 1-5 UFCF projections: $38M, $41M, $44M, $47M, $50M (reflecting modest revenue growth and stable margins)
- WACC: 10%
- Terminal value (Exit Multiple method): Year 5 EBITDA of $72M x 9.0x exit multiple = $648M
Discounting each year's UFCF and the terminal value back at 10%:
- PV of Year 1-5 cash flows: $38M/1.10 + $41M/1.21 + $44M/1.33 + $47M/1.46 + $50M/1.61 = $165M
- PV of terminal value: $648M/1.61 = $403M
- Implied enterprise value: $568M (roughly 9.5x current EBITDA)
Note that the terminal value ($403M) represents 71% of total value, which is typical. The team then runs a sensitivity table varying WACC from 9% to 11% and the exit multiple from 8x to 10x. The resulting range is $490M-$660M, which is wide enough to require triangulation with comps and LBO analysis.
Illustrative example based on typical PE valuation parameters
Quiz: DCF Analysis
6 questions · ~3 min