A discounted cash flow model values a business by estimating the cash it will produce and discounting those amounts back to today at a rate that matches the risk of those cash flows. A DCF checklist is a set of discipline tests that keep cash flows and discount rates internally consistent. Unlevered free cash flow is after tax operating cash before interest. The weighted average cost of capital is the blended required return for debt and equity used to discount that unlevered cash flow.
This guide shows how to build a DCF that stands up to sponsors, credit teams, and bankers. It focuses on clean cash definitions, evidence backed discount rates, and controls that prevent silent errors from creeping into valuation. The payoff is a model you can defend in committee and refresh in a day.
Context and objectives that shape a decision ready DCF
A DCF is not a price target or a comps table. It is a coherent forecast tied to a clear cash flow definition and a discount rate you can support with evidence. Sponsors focus on unlevered free cash flow and enterprise value. Credit teams care about cash taxes, working capital reversals, maintenance capex, and debt service under stress. Bankers care about auditability, sensitivities, and tie outs to market anchors. Build for all three from day one.
Define cash flow and map it precisely
Match the cash flow to the valuation approach and keep it consistent. In an unlevered DCF, start with EBIT, apply a cash tax rate, add depreciation and amortization, subtract capex and changes in net working capital, and adjust for non-operating items. Ignore financing flows and treat structural costs as operating.
Run these tests
- Reconcile UFCF: Tie last historical unlevered free cash flow to cash from operations minus capex, adjusting only for interest and non-operating items. Explain each difference line by line for credibility and faster reviews.
- Handle SBC consistently: If you add back stock based compensation in cash flow, reflect dilution in the equity bridge. This preserves per share valuation integrity.
- Avoid lease double counts: Document IFRS 16 and ASC 842 handling and treat leases once, not twice, so margins remain comparable and leverage is visible.
Build the revenue engine from units and price
Forecast revenue from how the business earns: volume, price, mix, and capacity. Model churn, cohort decay, backlog, seasonality, and conversion rather than assuming them away. Recognize revenue when performance obligations are met under IFRS 15 and ASC 606, not on cash receipt.
Run these tests
- Reconcile by driver: Match model revenue to audited history and management KPIs by volume and price drivers, not by percent growth, for traceability.
- Stress price and volume: If both climb beyond precedent, document the catalyst that drives that outcome to clarify risk.
- Expose FX mechanics: If foreign exchange matters, show currency drivers, hedge assumptions, and reporting vs functional currency to make translation risk explicit.
Make costs and operating leverage explicit
Classify costs as fixed, semi variable, or variable. Tie headcount, logistics, and major expenses to operational drivers. Track cost programs with timing, run rate, and one offs so margin math is clean and explainable.
Run these tests
- Bridge EBITDA from drivers: Build gross profit and SG&A from drivers and bridge to EBITDA without margin plugs for auditability.
- Validate gross margin: Link to input costs, mix, and pass through lags to keep forecasts realistic.
- Benchmark ruthlessly: Compare margins to peers and history. Any top quartile leap needs named actions on capacity, mix, or cost for credible optics with investment committees and lenders.
Model net working capital mechanics
Working capital is where many valuations drift. Model days sales outstanding, days inventory outstanding, days payables outstanding, deferred revenue, customer advances, and contract assets explicitly. Remember that growth slowdowns release or consume cash depending on the working capital structure.
Run these tests
- Anchor days to history: Compute historical days from financials, set initial forecasts accordingly, and phase improvements. This tightens cash timing.
- Track deferred revenue: Model deferred revenue separately and tie changes to bookings and delivery under IFRS 15 and ASC 606 to avoid revenue or cash double counts.
- Sensitize days: Move each lever by 5 to 10 days and check covenant headroom and liquidity in downside scenarios to improve refinancing certainty.
For deeper mechanics, see how to model working capital schedules in a three statement setup.
Capex, depreciation, amortization, and reinvestment discipline
Split capex into maintenance and growth. Link capex to capacity and unit growth, and let revenue follow assets when they are online. Match amortization schedules to product and legal lives so terminal cash flow is sustainable.
Run these tests
- Check growth math: Use the rule of thumb g ≈ ROIC × reinvestment rate. If growth is 3% and ROIC 12%, reinvestment should be about 25%. If the model shows 40%, explain mix or pre build to defend capital efficiency.
- Respect phasing: Reflect commissioning delays and do not book revenue before capacity starts to ensure timing accuracy.
- Amortize intangibles: Amortize acquired intangibles and capitalized development with realistic lives to avoid overstated terminal cash.
Taxes, interest limits, and new minimum tax regimes
Use cash taxes, not statutory rates. Model net operating loss usage with jurisdictional limits and expiries. Apply interest deductibility rules such as US 163(j), which caps net business interest deductions at 30% of EBIT for tax years starting in 2022. Consider OECD Pillar Two minimum tax regimes rolling out from 2024.
Run these tests
- Build a tax pack: Create a jurisdictional roll up and reconcile to the consolidated effective rate to improve cash visibility.
- Respect NOL limits: Apply valuation allowances and step up amortizations for acquisitions to smooth per share math.
- Include Pillar Two: If relevant, compute top up tax by jurisdiction and include it in unlevered free cash flow with safe harbor notes for medium term clarity.
Construct a defensible WACC with evidence
Match the discount rate to currency, inflation, and a steady state capital structure. Use a risk free rate in the cash flow currency. For USD, a representative 10 year Treasury yield was 4.30% on September 30, 2024 based on FRED. Base the equity risk premium on evidence, such as Kroll’s 5.5% for the US as of September 2024. Estimate beta bottom up from relevant peers, delever each, average, and relever to target leverage. Use size premia only when you can point to specific, measurable risk. Set cost of debt from actual spreads and base rates by tenor, and apply the tax shield consistent with the tax model and 163(j).
Run these tests
- Align currencies: Make risk free, inflation, and terminal growth consistent in currency to keep valuation coherent.
- Show beta ranges: Present a range and pick the median unless you have a strong reason to tilt. Document any adjustment to keep WACC defensible.
- Reconcile cost of debt: Tie to ratings based spreads or recent quotes. If comps trade at 8% and you use 6%, reconcile the gap to sustain lender credibility.
For a quick refresher on the mechanics of selecting a discount rate, see this practical walkthrough.
Terminal value that respects growth, ROIC, and capacity
Use a perpetual growth method or an exit multiple anchored to observable data. Keep perpetual growth at or below the long run nominal growth of the currency, using central bank inflation targets plus real GDP as an outer bound. Match exit multiples to terminal performance and cross check them to current and cycle averages. Ensure terminal cash is sustainable and that reinvestment implied by terminal growth satisfies the rule of thumb g ≈ ROIC × reinvestment rate. If terminal margins sit above peer top quartile, show the durable edge or fade them.
Run these tests
- Check EV share: If terminal value exceeds 70% to 80% of enterprise value in a volatile or young business, lengthen the explicit forecast or temper growth to balance risk.
- Cross check methods: Compare Gordon outcomes to an implied exit multiple and reconcile differences with ROIC and capital intensity.
- Match depreciation and capex: In capital heavy models, set terminal depreciation close to maintenance capex to avoid phantom cash.
Model capital structure and debt to expose refinancing risk
Even in unlevered DCFs, a detailed debt schedule reveals refinancing risk and covenant headroom. Calculate interest by tranche off average balances with proper accrual and payment timing. Use the revolver as the balancing item, subject to the borrowing base and availability limits.
Run these tests
- Bridge net debt: Reconcile sources and uses at close through each period and tie to financing cash flows for cash integrity.
- Stress interest: Move base rates and spreads and test covenants at EBITDA minus 10% and minus 20% to show survival odds.
- Bridge EV to equity: Walk from enterprise value to equity value, including net debt, preferred, minority interests, associates, and diluted shares for per share truth.
If you need a refresher on mechanics, review how a debt schedule works and how revolvers balance cash.
Scenarios, sensitivities, and model hygiene
Design scenarios as coherent states of the world, not just growth rate tweaks. Base, downside, and upside should move price, volume, margin, working capital, and capex with clear drivers. WACC and terminal growth sensitivities are standard; also add operating sensitivities tied to KPIs. Keep hygiene tight: centralize inputs on one assumptions sheet, use clear naming, avoid hardcodes in formulas, and control circularity with transparent iteration or algebraic fixes.
Run these tests
- Audit ranges: Check for range integrity and broken references. Prevent summing blanks or text to avoid late emergencies.
- Add reasonableness panel: Include EV multiples, ROIC vs WACC, cash conversion, leverage, and payback for a fast smell test.
- Validate inputs: Put data validation on key drivers and a diagnostic page for #REF, #DIV/0, sign, and unit flags to speed reviews.
If you build your DCF on a three statement model, wire the indirect cash flow statement cleanly to eliminate hidden circularities. An Excel DCF with a clean inputs tab is easier to audit.
Common mistakes can be costly. A quick refresher on avoiding DCF pitfalls can save hours.
Accounting and reporting alignment
Tie the DCF to the reporting framework. Revenue recognition follows IFRS 15 and ASC 606, with collection lags captured in receivables and contract assets. IFRS 16 and ASC 842 push lease costs into interest and principal and lift EBITDA. Rebuild history and peers for apples to apples.
Run these tests
- Lease adjusted EBITDA: When peers report pre IFRS 16, rebuild and reconcile both ways for comparable multiples.
- Capitalize consistently: Confirm capitalization of development and software costs and amortize in EBIT and unlevered free cash flow to keep margin comparability.
- Align tax disclosures: Tie ASC 740 or IAS 12 disclosures to the cash tax model and reconcile deferred taxes to temporary differences for audit readiness.
Governance, documentation, and evidence
Keep a sourcing log for every external rate, spread, multiple, and market anchor with as of dates and links. Use a change log and version control, date and describe each material change, and lock delivered files.
Run these tests
- Assumptions passport: Compile risk free, ERP, beta, cost of debt by tranche, tax rates, long run growth, FX, and commodity curves with sources for faster signoff.
- Hard stop flags: Catch working capital sign flips, terminal growth above nominal trend, multi year ROIC below WACC without fix, and base case DSCR below 1.0x for early course correction.
- Track open issues: Log reviewer notes. If unresolved, park a conservative placeholder or scenario to protect decisions.
Cross check to market anchors
A standalone DCF should rhyme with observable markets. Compare implied multiples and growth to return patterns to trading comps and deals. For credit, align coverage and leverage with current underwriting.
Run these tests
- Show a range: Present a valuation range with scenario and sensitivity bands. Use a point estimate only if a decision requires it for better expectation management.
- Track multiple path: Show how the DCF implied multiple evolves from year 1 to terminal. A falling multiple with rising growth signals reinvestment or discount rate inconsistency.
- Reconcile per share: Use the treasury stock method for diluted shares and include convertibles, warrants, and performance equity for accuracy.
Implementation plan and owners
Assign owners for drivers: revenue to commercial, costs and headcount to operations and HR, capex to engineering, tax to the tax team or advisor, and WACC to valuation. Stage the work: Weeks 1 to 2 rebuild history and KPIs. Weeks 3 to 4 build the base case, debt, and tax pack. Week 5 finalize scenarios, WACC, and terminal value. Week 6 audit, document, and prepare committee materials.
Run these tests
- Dry run early: Hold a dry run at the end of Week 3 to fix structural issues before polishing to save time.
- Freeze inputs: Lock inputs 48 hours before committee and route changes through a redlined memo to maintain control.
- Summarize succinctly: Produce an executive summary with enterprise value range, equity range, top drivers, top three risks, and the two most value sensitive variables for clear decisions.
Common pitfalls and hard stops to enforce
- Mixed cash flows: Unlevered cash contaminated with interest or buybacks. Hard stop: trace interest and confirm it does not touch unlevered free cash flow.
- Currency mismatch: Discounting EUR cash flows with a USD WACC. Hard stop: tag every exogenous rate and cash line by currency.
- Terminal overreach: Perpetual growth above nominal trend. Hard stop: require terminal growth minus inflation to be less than or equal to long run real growth.
- Reinvestment gap: Growth without support from working capital or capex. Hard stop: reconcile g or ROIC implied reinvestment to modeled reinvestment.
- Tax optimism: Terminal tax drops with no jurisdictional shift. Hard stop: terminal tax equals the weighted jurisdictional mix.
- Cherry picked beta: A single low beta peer. Hard stop: use an 8 to 12 peer set with quartiles.
- Lease double count: Charge lease in operating expense and financing outflow. Hard stop: reconcile EBITDA, EBIT, and unlevered free cash flow under lease adjusted and unadjusted views.
- Deferred revenue errors: Bookings treated as revenue and cash. Hard stop: bookings lift deferred revenue, revenue recognized on performance.
- Hidden circularity: Iteration hides negative cash. Hard stop: turn off iteration and fix logic if outputs fail.
- Excess precision: Dollar precision with wide risk ranges. Hard stop: present rounded ranges with drivers.
Deliverables that speed diligence
Deliver a concise pack that stands on its own. Include a driver bridge from EBITDA to unlevered free cash flow, WACC construction with sources and dates, terminal value support, and a valuation range with sensitivities. For credit, include a liquidity and covenant dashboard. Attach the sourcing log, change log, and a model map showing sheet purpose and data flow. Provide a PDF of key pages and an Excel with protected structure and unlocked inputs.
What “good” looks like in practice
Cash flows and discount rates line up in the same currency and inflation regime. Growth ties directly to reinvestment and returns. Taxes, leases, and stock based compensation withstand accountant and lender review. Scenarios are plausible, sensitivities are transparent, and any gap to market multiples is explained by specific operating levers. You can refresh the model in a day because assumptions are centralized, sources documented, and formulas scale with time. Simple, consistent, and conservative beats ornate.
Closeout for compliance certainty
Archive the full record, including index, versions, reviewer Q&A, user list, and change and audit logs. Hash the package, apply the retention policy, obtain vendor deletion and destruction certificates, and note that legal holds override deletion.
A fast pre-mortem to catch failures early
Before finalizing, run a 30 minute pre-mortem. Ask what would make this DCF wrong by 30%. Usually it is one of three things: overstated terminal growth, understated working capital investment, or an equity risk premium that ignores current credit spreads. Then run a single page test: move terminal growth down 50 bps, extend payables 5 days in a downturn, and lift ERP 50 bps. If the range collapses below the decision threshold, escalate. This small ritual prevents most costly reworks.
If debt complexity is the risk center, skim this note on debt scheduling to pressure test timing, cash sweeps, and covenants.
Conclusion
A disciplined DCF is a finance product, not a spreadsheet. Define cash cleanly, evidence the discount rate, model reinvestment with rigor, and memorialize sources and choices. With these checks, your valuation will be coherent, review ready, and aligned with how decisions are made.