How to use the DCF calculator
The Intrinsic value tool runs a two-stage model. Start with the company’s free cash flow, then set the assumptions:
- Free cash flow, last 12 months, in millions of dollars. Free cash flow is operating cash flow minus capital expenditure. If the last year was unusual, use a normalized figure or an average of several years.
- Growth for years 1–5 and 6–10. Most companies cannot sustain high growth, so the second rate is usually lower than the first.
- Terminal growth: the rate at which cash flow grows forever after year 10. It should not exceed long-run growth of the economy, so 2% to 3% is the usual range.
- Discount rate: the return you require, usually the company’s WACC.
- Net debt and shares outstanding convert the value of the whole business into a value per share.
- Share price, if you want the margin of safety.
The Reverse DCF tool starts from the price instead, and finds the growth rate the market is paying for.
How the model works
A DCF values a business as the sum of all its future free cash flows, each discounted back to today:
Terminal value TV = FCF10 × (1 + g) ÷ (r − g)
Equity value = Enterprise value − Net debt
Value per share = Equity value ÷ Shares outstandingFCFt is free cash flow in year t, r the discount rate and g the terminal growth rate. The sum runs over years 1 to 10.
The terminal value uses the Gordon growth formula: a cash flow that grows at a constant rate forever is worth its next payment divided by the difference between the discount rate and the growth rate. That is why the discount rate must be higher than the terminal growth rate; when the two get close, the value explodes towards infinity.
A worked example
A company generated $1,000M of free cash flow last year. You expect it to grow 10% a year for five years, then 6% for five more, and 2.5% forever after. You require 9% a year.
The ten projected cash flows are worth $9.96B today, and the years after that add $14.36B. Enterprise value is $24.31B.
Subtracting $2,000M of net debt leaves an equity value of $22.31B, or $44.62 per share across 500 million shares.
Against a share price of $40, that is an upside of +11.6% and a margin of safety of 10.4%.
Why the answer is so sensitive
Small changes to the long-run inputs move the result a lot, because they affect every year from 11 onwards:
| Change from the example | Value per share |
|---|---|
| The example (WACC 9%, terminal growth 2.5%) | $44.62 |
| Discount rate 8% instead of 9% | $54.15 |
| Discount rate 10% instead of 9% | $37.67 |
| Terminal growth 1.5% instead of 2.5% | $40.55 |
| Terminal growth 3.5% instead of 2.5% | $50.18 |
| Growth 5% then 3% instead of 10% then 6% | $31.68 |
Moving the discount rate one point either way takes the value from $37.67 to $54.15: at 10% the shares look expensive at $40, at 8% they look clearly cheap. The sensitivity table under the calculator shows the full grid of discount and terminal growth rates; green cells are above the share price and red cells below.
This sensitivity is not a flaw of the calculator but the nature of valuation. A DCF does not produce the value of a stock; it shows what the stock is worth under a stated set of assumptions. Its real use is to make those assumptions explicit, so you can judge whether they are reasonable.
Reverse DCF: what is the price assuming?
Because growth forecasts are so uncertain, many investors run the model in reverse. Enter the current price and the tool finds the constant growth rate that makes the DCF value equal the price.
In the example, a price of $40 implies free cash flow growth of 6.9% a year for 10 years, after which cash flow would be 2.0× today’s level. The question then becomes simpler: is that growth more or less than you believe the company can deliver? If the business has grown cash flow by 15% a year and has room to keep going, a price that assumes 7% may be cheap. If the price assumes growth the company has never achieved, the shares are priced for perfection.
Choosing the inputs
- Free cash flow. Check several years. Capital spending is lumpy, and one year of unusually low investment can flatter free cash flow. Stock-based compensation is a real cost even though it does not reduce cash flow; some analysts subtract it.
- Growth rates. Base them on revenue growth, margins and reinvestment, not on the last year alone. High growth rarely lasts ten years, which is why the model uses two stages.
- Discount rate. Our WACC and CAPM calculators estimate it from the cost of equity and debt. A higher rate builds in more caution.
- Net debt. Include leases and other debt-like items if they are material. If the company holds more cash than debt, net debt is negative and adds to the value of the shares.
- Shares. Use the diluted count, which includes options and convertible securities.
Limitations
A DCF is only as reliable as its inputs, and the most important inputs, long-run growth and the discount rate, cannot be known precisely. The model also assumes the business survives and keeps its competitive position for decades. Use the result as one view alongside multiples, the company’s history and its balance sheet, and prefer a margin of safety large enough to absorb reasonable errors in your assumptions.