🧮 DCF Calculation: Complete Step-by-Step Method

DCF is the valuation method 95% of Wall Street analysts use. In 15 minutes you'll know how to compute it yourself, understand WACC and terminal value, and avoid the traps that produce delirious fair values.

📘 What is a DCF?

DCF stands for Discounted Cash Flow. The fundamental idea: a company is worth the sum of all the cash it will generate in the future, brought back to today's value. Why "brought back"? Because $1 in 10 years is worth less than $1 today (inflation + risk + opportunity cost).

DCF is used by every analyst at Goldman, JP Morgan, Morgan Stanley. Warren Buffett popularized it for retail under the name "intrinsic value". It's the method to answer: "is this stock cheap or not?"

🪜 The 5 calculation steps

Step 1 — Project Free Cash Flows for 5 to 10 years

Free Cash Flow (FCF) = Operating cash flow − CAPEX. The cash actually available to investors after the company has paid for operations and reinvestment.

Start from last year's FCF. Project a decaying growth rate over 5-10 years: e.g. 15% → 12% → 9% → 6% → 4%. The more mature the company, the faster the decay.

Step 2 — Compute the WACC

WACC is the discount rate. Details in section 3, but in practice: between 6% (stable mega-cap) and 12% (risky small cap). Apple: ~8-9%. Tesla: ~10-11%. Biotech: 14-18%.

Step 3 — Estimate terminal value

Beyond the projection period, assume the company generates FCFs forever with constant growth g (typically 2-3%). Gordon-Shapiro formula:

TV = FCF(n+1) / (WACC − g)

Step 4 — Discount all cash flows

Each future FCF is divided by (1 + WACC)^t, where t is the number of years. Sum = Enterprise Value (EV).

Step 5 — Equity Value and per-share price

Equity Value = Enterprise Value − net debt (debt − cash). Divide by diluted share count and you get the fair value per share. Compare to market price: margin of safety ≥ 25% before buying (Graham rule).

🎓 WACC explained simply

WACC = Weighted Average Cost of Capital. What the company's capital costs when you blend debt and equity.

WACC = (E/V × Re) + (D/V × Rd × (1 − t))

• E/V = equity weight (Equity / total value)
• Re = cost of equity (CAPM: Re = Rf + β × market risk premium)
• D/V = debt weight (Debt / total value)
• Rd = cost of debt (average interest rate)
• t = tax rate (interest is tax-deductible)

💡 Tip — Don't want to compute CAPM by hand? Alpha's DCF module fetches beta (FMP/Finnhub), risk-free rate (live 10Y US Treasury), and capital structure automatically. WACC computed in 1 second.

⚠️ Terminal value: the killer trap

• g ≤ long-term GDP growth (max 3% for developed economies).
• Run sensitivity analysis: DCF with g = 2%, 2.5%, 3%. Three fair values give you a range.
• Alternative: exit multiple. Multiply terminal EBITDA by a sane multiple (12-18×) instead of Gordon-Shapiro. Often more conservative.

🍎 Worked example: Apple DCF (FY2025)

Simplified assumptions (May 2026):

• FCF FY2024: $108B
• Projected growth: 8%, 7%, 6%, 5%, 4% over 5 years
• WACC: 8.5%
• g (perpetual): 2.5%
• Net debt: -$50B (net cash positive)
• Diluted shares: 15.0B

Terminal value: TV = 144.5 × 1.025 / (0.085 − 0.025) = 148.1 / 0.06 = $2,468B. Discounted: 2,468 × 0.665 = $1,641B.

Enterprise Value: 513.5 + 1,641 = $2,155B.

Equity Value: 2,155 − (−50) = $2,205B.

Fair value per share: 2,205 / 15.0 = $147.

If AAPL trades at $180, the market pays a ~22% premium over this conservative estimate. For a 25% margin of safety, entry would have to be ≤ $110. Verdict: not a bargain at $180, but accumulation zone below $130.

🚫 DCF limits

1. Hyper-sensitive to assumptions. +1% on g = +20% on fair value. Always run 3 scenarios.
2. Useless for unprofitable companies. Tesla 2018, Snowflake 2021, Reddit 2024 — negative FCF = no DCF. Use multiples (EV/Sales) or DCF with delayed FCF positivity.
3. Bad for cyclicals. Steel, auto, oil — erratic FCF. Prefer 10-year average + normalized multiples.
4. Doesn't capture optionality. Apple Vision Pro, Microsoft + OpenAI, Tesla robots — value of future bets isn't in the DCF.
5. Garbage in, garbage out. If your growth projections are inflated by management's narrative, so is your fair value.

🧮 Free DCF calculator (Alpha)

You can do this all by hand in Excel (free template from Damodaran), or use Alpha's DCF Calculator module which:

• Auto-fetches 10-year historical FCFs (FMP)
• Computes WACC live (beta + 10Y Treasury + cap structure)
• Runs 3 scenarios (bear / base / bull) with sensitivity table
• Generates AI reasoning (why these assumptions, vs analyst consensus)
• Cost: ~$0.04 per DCF with Sonnet 4.6 (cost details)

❓ FAQ