A company's value is the sum of all the cash it will ever generate, adjusted for the fact that money tomorrow is worth less than money today. That's the DCF principle in one sentence. Everything else is the mechanics of putting numbers to this idea.
The three components
The mechanics
Each year's cash flow is divided by (1+discount rate) raised to the power of how many years away it is. A £100 cash flow in year 5 at a 10% discount rate is worth £100 / 1.1⁵ = £62.09 today. Future cash flows are worth less because of inflation, risk, and the opportunity cost of capital.
The terminal value problem
In most DCFs, the terminal value represents 60–80% of the total valuation. This is the value of all cash flows beyond the forecast period, calculated as a growing perpetuity: Terminal Value = FCF × (1+g) / (r−g), where g is the long-term growth rate. A change of 0.5% in your growth assumption can swing the terminal value by 20–30%. This is why DCF models are sometimes dismissed as "garbage in, garbage out."
Sensitivity analysis
Because DCF outputs are so sensitive to inputs, professional analysts always build sensitivity tables — showing how the valuation changes across different WACC and growth rate combinations. A robust DCF shows you a range of outcomes, not a single point estimate.
| WACC Growth | 2% | 3% | 4% |
|---|---|---|---|
| 8% | £95 | £115 | £145 |
| 10% | £70 | £80 ← base | £95 |
| 12% | £52 | £58 | £67 |
What this means for you
DCF is the right framework for thinking about intrinsic value — but treat any single DCF output with scepticism. The real value of building a DCF isn't the number it spits out; it's the discipline of thinking through the business's growth prospects, margins, and capital requirements explicitly. When a company is trading at a large discount to your DCF range, that's your margin of safety. When it's above the range under all scenarios, it's hard to justify buying.
A DCF is a powerful way to be wrong with precision. Build one anyway — the process of thinking through the assumptions is more valuable than the output.