How to Build a DCF (Discounted Cash Flow) Model

What a DCF is, and why interviewers ask about it

A discounted cash flow model values a company on its own terms: the cash it is actually expected to generate, discounted back to a value in today's dollars. That makes it an intrinsic valuation method, as opposed to trading comps or precedent transactions, which value a company by reference to what the market is paying for similar businesses right now. Neither approach is “correct” on its own, which is exactly why real valuation work builds a DCF alongside comps and checks that the two tell a consistent story.

Interviewers lean on the DCF walkthrough specifically because it cannot be answered from memorized rules of thumb. Doing it correctly requires understanding why cash flow differs from accounting earnings, why the discount rate has to match the cash flow it is discounting, and why a terminal value assumption can dominate the entire answer. A candidate who can walk through it cleanly has demonstrated they understand how a business actually creates value, not just where to find a multiple.

At the highest level, building one means: project unlevered free cash flow for an explicit forecast period (commonly five to ten years), discount each year back to today at the weighted average cost of capital, add a terminal value standing in for every year beyond the forecast, and sum the whole thing to get enterprise value. From there, a short bridge gets you to equity value and a per-share price.

Step 1: project unlevered free cash flow

Unlevered free cash flow (UFCF) is the cash a business generates from its core operations, available to every capital provider, debt and equity alike, before any financing decisions are made. Because it is pre-financing, it is the cash flow that gets discounted at WACC, a rate that itself blends the return required by both debt and equity holders (see our WACC guide).

Each piece exists for a specific reason. Start from EBIT, not net income, because a DCF is meant to value the operating business independent of how it happens to be financed; net income already has interest expense baked in, and including it here would double-count financing effects once the discount rate itself also reflects the cost of debt. Taxing EBIT directly gives NOPAT (net operating profit after tax), the after-tax profit the business would earn with no debt at all.

Depreciation and amortization get added back because they reduced EBIT as an expense but never actually used any cash. Capital expenditures get subtracted because they are a real cash outflow, spent to maintain or grow the asset base, that never shows up as an expense on the income statement. An increase in net working capital (receivables plus inventory, net of payables) is subtracted because a growing business typically has to fund more of its own operating cycle in cash before that cash comes back in; a decrease in net working capital would instead be added, since it frees up cash.

Worked example: EBIT of $100mm, a 25% tax rate, $20mm of D&A, $30mm of capex, and a $10mm increase in net working capital.

Step 2: why you discount at WACC

Unlevered free cash flow belongs to everyone who has a claim on the business, debt and equity holders together, so it has to be discounted at a rate that reflects what both of them require. That rate is the weighted average cost of capital: the cost of equity and the after-tax cost of debt, each weighted by its share of the company's capital structure at market value. Using the cost of equity alone would understate the discount rate whenever the company carries meaningful debt, overstating the resulting valuation. The full derivation, including CAPM for the cost of equity, lives on the WACC guide.

The one case where WACC is not the right rate is if you are instead discounting levered free cash flow, cash flow already net of interest expense and debt paydown, which belongs to equity holders only and gets discounted at the cost of equity directly to arrive at equity value. The unlevered-FCF-at-WACC approach covered here is the far more common version asked about in interviews.

Step 3: terminal value, two ways

No one forecasts cash flow forever, so the DCF needs a terminal value standing in for every year of cash flow beyond the explicit projection period, as of the final forecast year. There are two standard ways to build it, and a careful answer computes both as a cross-check on each other.

1. Gordon Growth (perpetuity growth) method. Assume the final year's cash flow grows at a constant rate forever, and value that growing perpetuity:
   Terminal Value = Final Year FCF × (1 + g) ÷ (WACC − g)
   where g is a modest long-run growth rate, usually pinned near long-run GDP or inflation (often 2% to 3%), and must be strictly less than WACC or the formula turns negative or explodes. Economically, no company can outgrow its own discount rate forever.
2. Exit multiple method. Apply a valuation multiple, most often EV/EBITDA, to the final projection year's metric, using a multiple drawn from where comparable public companies trade today (see the trading comps guide):
   Terminal Value = Final Year EBITDA × Exit Multiple

Because both methods are valuing the same thing, a good sanity check is to solve each method for what it implies about the other: the growth rate a given exit multiple implies, or the multiple a given growth rate implies. If that implied figure looks unreasonable next to how the sector actually trades or actually grows, the underlying assumption needs revisiting.

Step 4: discount everything to present value and sum

Every projected year of unlevered free cash flow, plus the terminal value (itself a value as of the final forecast year, so it needs discounting back the same number of years as that final year's cash flow), gets discounted to today at WACC:

Summing every discounted cash flow plus the discounted terminal value gives the DCF's implied enterprise value. Worked example, keeping the numbers simple: two years of $100mm unlevered free cash flow, a 10% WACC, and a terminal value of $1,000mm as of the end of year two.

Notice how much of the total came from the terminal value alone (roughly 83% in this example). That is normal, and it is exactly why interviewers spend so much time pressure-testing terminal value assumptions specifically.

Step 5: bridge enterprise value to equity value to per-share value

A DCF's output, enterprise value, is the value of the whole operating business before considering how it happens to be financed. To get to what common shareholders actually own, subtract every other claim on the business and add back cash, which effectively belongs to equity once debt is repaid. The full mechanics of this bridge are covered on the enterprise value guide.

Dividing equity value by diluted shares outstanding gives value per share. Continuing the example above: enterprise value of $1,000mm, debt of $200mm, cash of $50mm, and no preferred stock or minority interest.

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