The short answer: Forecasting free cash flow for a DCF means projecting unlevered cash flow until growth, margins, and reinvestment settle, then valuing every year after that point as a terminal value. In the modelled $24,000K company below, a 5-year forecast produces $18,264K of undiscounted free cash flow and a $56,301K enterprise value, with terminal value supplying 77.2% of it.
- Unlevered free cash flow equals NOPAT plus depreciation and amortization, minus capital expenditures and the increase in net working capital.
- A forecast horizon is long enough when extending it stops moving value. In the model, stretching from 7 to 10 years changes enterprise value by 0.2%.
- Terminal growth stays below the growth of the economy. The 10-year Treasury yielded 5.01% on September 18, 2026.
- Undiscounted cash flows are the same forecast summed before any discount rate applies, and ASC 360-10-35-17 uses that sum as an impairment screen.
Last updated September 2026.
A discounted cash flow model is only as reliable as the free cash flow forecast beneath it. Three decisions drive most of the result. The first is how many years to project. The second is how to close the projection with a terminal value. The third is whether a given test uses discounted or undiscounted cash flows.
The worked model below values a modelled B2B services company with $24,000K of trailing revenue. Every figure is illustrative and stated in thousands of dollars. Each line is rounded before it feeds the next, so every table foots to the dollar shown.
What goes into forecasting free cash flow for a DCF?
Unlevered free cash flow is the cash an operating business generates before financing costs. It equals net operating profit after tax (NOPAT), plus depreciation and amortization, minus capital expenditures, minus the increase in net working capital. Each component is forecast from its own driver rather than from last year’s total.
The model grows revenue 18%, 15%, 12%, 9%, and 7% across five years and lifts the EBIT margin from 12% to 18%. Tax applies at 21%, the federal rate printed in the IRS Form 1120 instructions; state income tax is excluded for simplicity. Depreciation runs 3% of revenue and capital expenditures 4%. Net working capital holds at 12% of revenue, so each year’s build equals 12% of the revenue increase.
| Line item ($K) | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 |
|---|---|---|---|---|---|
| Revenue | 28,320 | 32,568 | 36,476 | 39,759 | 42,542 |
| EBIT | 3,398 | 4,560 | 5,836 | 6,759 | 7,658 |
| Taxes at 21% | 714 | 958 | 1,226 | 1,419 | 1,608 |
| NOPAT | 2,684 | 3,602 | 4,610 | 5,340 | 6,050 |
| Plus depreciation and amortization | 850 | 977 | 1,094 | 1,193 | 1,276 |
| Less capital expenditures | 1,133 | 1,303 | 1,459 | 1,590 | 1,702 |
| Less increase in net working capital | 518 | 510 | 469 | 394 | 334 |
| Unlevered free cash flow | 1,883 | 2,766 | 3,776 | 4,549 | 5,290 |
Year 1 shows the arithmetic: $2,684K of NOPAT, plus $850K of depreciation and amortization, minus $1,133K of capital expenditures and $518K of working-capital build, equals $1,883K. Free cash flow reaches $5,290K by year 5. Margin expansion and a shrinking working-capital build (from $518K to $334K) outpace higher capital spending.
This view differs from an operating liquidity forecast. The 13-week and 12-month cash flow forecast tracks whether the business can fund payroll next month. A DCF forecast values the business over 5 to 10 years.
How many years should you forecast free cash flow?
Forecast until growth, margins, and reinvestment reach rates the company could sustain indefinitely. The test is empirical: extend the horizon until enterprise value stops moving. In the model, that point arrives near year 7.
Ending at year 3 forces the terminal formula to assume growth falls from 12% to 3% overnight. That lands enterprise value $9,109K (16.2%) below the 5-year result. Extending from 5 to 7 years adds $934K (1.7%). Extending from 7 to 10 years subtracts $121K (0.2%), so the value has converged.
| Horizon | Undiscounted FCF ($K) | PV of FCF ($K) | PV of terminal value ($K) | Enterprise value ($K) | Terminal share |
|---|---|---|---|---|---|
| 3 years | 8,425 | 6,702 | 40,490 | 47,192 | 85.8% |
| 5 years | 18,264 | 12,838 | 43,463 | 56,301 | 77.2% |
| 7 years | 29,842 | 18,714 | 38,521 | 57,235 | 67.3% |
| 10 years | 48,943 | 26,192 | 30,922 | 57,114 | 54.1% |
Terminal value carries 85.8% of the result at 3 years and 54.1% at 10 years. A share that high means the horizon, not the business, is doing the valuing. Every row uses the same 11.0% discount rate, 3.0% perpetual growth, and year-by-year growth path that fades from 18% to 3%.
How do you calculate terminal value in a DCF?
Terminal value capitalizes the free cash flow of the first year after the forecast. The formula is year-6 free cash flow ÷ (WACC − g), where g is the perpetual growth rate. Build year 6 from normalized drivers, because year 5 still carries growth-phase reinvestment.
With an 11.0% WACC and 3.0% perpetual growth, normalized year-6 revenue is $43,818K (year 5 × 1.03). NOPAT is $6,231K and depreciation $1,315K. Capital expenditures settle at 3.5% of revenue ($1,534K), and the working-capital build shrinks to $153K because growth slows to 3%. Year-6 free cash flow is $5,859K, so terminal value = $5,859K ÷ (0.11 − 0.03) = $73,238K.
Discounted five years at 11.0%, that terminal value is worth $43,463K today. Add $12,838K of discounted forecast cash flows and enterprise value is $56,301K. Simply growing year-5 free cash flow by 3% gives $5,449K and a terminal value of $68,113K, which is $5,125K too low. The year-5 working-capital build was sized for 7% growth.
“Since no firm can grow forever at a rate higher than the growth rate of the economy in which it operates, the constant growth rate cannot be greater than the overall growth rate of the economy.” — Aswath Damodaran, NYU Stern
Damodaran adds a rule of thumb: the stable growth rate should not exceed the riskless rate used in the valuation. The US Treasury yield curve put the 10-year at 5.01% on September 18, 2026. The model’s 3.0% sits 2.01 points below it.
A multiple check catches errors the formula hides. The $73,238K terminal value equals 8.2 times year-5 EBITDA of $8,934K. A multiple outside the range at which comparable companies transact signals an aggressive growth or discount-rate assumption.
How sensitive is a DCF to the discount rate and terminal growth?
Enterprise value moves more with the discount rate than with terminal growth in this model. A one-point change in WACC shifts value by $6,895K to $8,897K (12.2% to 15.8%). A one-point change in perpetual growth shifts it by $4,875K to $6,268K.
| Enterprise value ($K) | g = 2.0% | g = 3.0% | g = 4.0% |
|---|---|---|---|
| WACC 10.0% | 58,647 | 65,198 | 73,932 |
| WACC 11.0% | 51,426 | 56,301 | 62,569 |
| WACC 12.0% | 45,672 | 49,406 | 54,073 |
The spread between the lowest and highest cell is $28,260K, or 50.2% of the base case. A valuation delivered as one number hides that range. A grid like this one states it.
What are undiscounted future cash flows?
Undiscounted future cash flows are forecast cash flows summed at face value, before any discount rate applies. US GAAP uses that sum as the first-step recoverability screen for long-lived assets held and used. In the enterprise model, five undiscounted cash flows total $18,264K, and discounting at 11.0% reduces them to $12,838K.
ASC 360-10-35-17 defines the screen. A carrying amount is not recoverable “if it exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset (asset group).” The wording is quoted in correspondence filed with the SEC. Only a failed screen leads to a loss measured against fair value.
Take an asset group with a $9,200K carrying amount and six years of expected cash flows of $1,450K, $1,520K, $1,590K, $1,650K, $1,700K, and $1,750K, plus $600K of disposition proceeds. The downside case cuts every figure by 15%.
| Scenario | Undiscounted sum ($K) | Carrying amount ($K) | Recoverable? | PV at 11.0% ($K) | Loss recognized ($K) |
|---|---|---|---|---|---|
| Base case | 10,260 | 9,200 | Yes, $1,060K cushion | 7,055 | 0 |
| Downside, 15% lower | 8,723 | 9,200 | No, $477K shortfall | 5,998 | 3,202 |
The base case passes the screen even though its discounted value sits $2,145K below the carrying amount. Discounting sizes a loss, and the undiscounted sum decides whether one exists. In the downside case, the loss is $9,200K − $5,998K = $3,202K, with fair value assumed here to equal the present value at 11.0%.
What does a reliable forecast base year require?
A forecast inherits every error in its base year. The base year needs reconciled cash, cut-off-tested revenue, supported working-capital balances, and capital expenditures separated from repairs. At a 12.5 times capitalization factor (1 ÷ 0.08), each $100K of misstated recurring free cash flow shifts terminal value by $1,250K.
The Continuous Close Method™ ties cash, receivables, payables, and fixed assets to source evidence every month, so the base year reflects reconciled balances instead of year-end estimates. Kevin Cahill reviews each base-year close packet before any forecast is built on it. The month-end close benchmarks show how long that discipline takes at each company size, and the startup financial statements guide covers how the three statements tie together.
Frequently asked questions
How long do you have to forecast free cash flow for a valuation?
Long enough for growth, margins, and reinvestment to stabilize, which the model above reaches near year 7. Extending from 7 to 10 years changed enterprise value by 0.2%, while stopping at year 3 left it 16.2% below the 5-year result.
How do you get the future cash flows in a DCF?
Project revenue, EBIT margin, tax, depreciation, capital expenditures, and working capital as separate drivers. Compute NOPAT, add depreciation, and subtract reinvestment. Year 1 of the model: $2,684K + $850K − $1,133K − $518K = $1,883K.
What are undiscounted future cash flows?
Forecast cash flows summed at face value before a discount rate applies. ASC 360-10-35-17 compares that sum with an asset group’s carrying amount to decide whether an impairment loss exists. In the example, the base-case sum of $10,260K exceeds the $9,200K carrying amount, so no loss is recorded.
Which tax rate applies to forecast free cash flow?
The model applies 21%, the federal corporate rate on the IRS Form 1120 instructions. A company forecast also adds state income tax and timing differences, which should come from the company’s own tax return position.
