How do you perform discounted cash flow analysis?

Discounted cash flow analysis begins with projecting the cash flows a business will generate over a defined forecast period. Free cash flow to the firm or free cash flow to equity is derived from revenue assumptions, operating margins, working capital needs, and capital expenditures. Aswath Damodaran at New York University Stern School of Business emphasizes documenting each assumption and tying projections to observable drivers such as market growth, capacity constraints, and management plans. Transparent assumptions allow peers and stakeholders to evaluate whether forecasts are optimistic or conservative.

Projecting cash flows
Forecasts typically cover an explicit period followed by a terminal value to represent cash flow beyond the forecast horizon. Two common terminal approaches are perpetual growth and exit multiple. The choice matters because the terminal component often represents a large share of total value. Analysts must justify the long run growth rate using macroeconomic expectations and industry maturity, and consider structural shifts such as technological change, regulatory trends, and resource depletion that can alter long-term returns.

Choosing a discount rate
Discounting converts future cash flows into present value using a rate that reflects time value and risk. The weighted average cost of capital is used when valuing the whole firm and blends cost of equity and cost of debt, while cost of equity is used for cash flows to equity. The CFA Institute advises that estimates of beta, default spreads, and country risk premia be grounded in market data and adjusted for the firm’s specific capital structure and operating exposure. For firms operating in emerging markets, analysts should account for additional political, currency, and liquidity risks, which raise discount rates and lower valuations.

Sensitivity and scenario analysis
Because DCF values are highly sensitive to a few inputs, rigorous sensitivity or scenario analysis is essential. Varying the discount rate and terminal growth rate shows value ranges and highlights which assumptions drive outcomes. Investors and managers should consider downside scenarios such as demand shocks, supply chain disruptions, or tightened environmental regulations that could materially reduce cash flows. Ignoring such scenarios can produce misleadingly precise valuations and poor capital allocation decisions.

Relevance, causes, and consequences
DCF is relevant for corporate finance, investment appraisal, and public policy decisions because it links future economic benefits to present resource allocation. Causes of valuation divergence include overly optimistic growth expectations, mismeasured risk premiums, and failure to integrate nonfinancial factors. Consequences of misvaluation range from inefficient investment and mispriced securities to broader social impacts when capital is directed away from sustainable or resilient enterprises. Cultural and territorial nuances influence inputs and interpretations. Local accounting practices, governance quality, and societal attitudes toward risk and long term planning shape both the data available and the credibility of management forecasts. Environmental considerations such as climate risk and resource constraints increasingly alter cash flow trajectories and must be integrated to produce defensible, high-quality DCF valuations.