In some cases, replacing water damaged drywall is the only option. You have examined the damaged area and it is clear that you need more than paint. It is best to remove the compromised drywall and replace it with new drywall.
See the article 'Water Stains on Drywall' for information on sealing a stain without removing the drywall.
Examining the Damaged Drywall
You need to determine how much drywall needs to be removed. Too much water will deteriorate the paper facing and weake the core of drywall. When this happens, the old drywall needs to be removed and new drywall installed.
Is the drywall mushy and the paper easily torn? Is the paper separating from the surface of the gypsum? Has it sagged and pulled away from the framing members? Are the fasteners rusty and popped through the paper? Is there mold on the drywall?
A yes answer to one or more of the questions in the previous paragraph will mean that the drywall needs to be replaced.
If the water stain appears to be only on the surface of the drywall and it has dried completely, you may be able to seal it and re-paint.
Fixing the Leak
There is no point in repairing the drywall if you have not stopped the leak that is damaging the drywall. Water intrusion that ruins drywall can come from a number of sources. A leaking roof is certainly a candidate. Plumbing leaks are also common culprits.
Removing the Bad Drywall
Drywall is fastened to the wood framing with either screws or nails and sometimes glue. To remove it, you need to locate the framing members. If you don't you will have to add additional supports to fasten the drywall to.
Locating Framing Members
Once you have determined how much drywall needs to be removed, you want to lay this out on the wall surface. The make the installation of the new drywall simpler, you want to use a straight edge to mark out the area to be cut out. Ideally, it will be a square or a rectangle. You can use a stud finder to locate the stud framing.
Try to lay out the cut out area so that the edges that are paralell to the stud framing are centered on thed studs. It is harder to cut out the drywall at these locations, but is saves having to install extra framing members.
Cutting Perpendicular to the Studs
You can use a key hold saw to cut out the drywall that is perpendicular to the stud framing. You will have to stop at each stud or joist and skip over it. You should be able to get the majority of the cut done with the keyhold saw. You will need to finish off the cut over the framing with a utility knife.
Cutting Drywall Paralell With the Framing
You will need to use a utility knife to cut the drywall over the framing members. Ideally, you have located the center of the framing and drawn a line down the center. Initially, you will score this line with a utility knife. After you have scored the paper, you will run the utility knife over the cut repeatedly, applying more pressure each time until you cut completely through the drywall.
Replacing the Damaged Drywall
Installing new drywall involves cutting the sheets to the correct size and then fastening it in place. There are various measurements that need to be taken and laid out on the drywall panel. After that, the drywall needs to be cut correctly. Once the sheet is cut, it can be installed at the patch.
The article 'How To Cut Drywall' has instructions on all of the steps associated with installing new drywall patches.
Finishing the New Drywall Patch
After you have installed the new drywall where you tore out the old damaged drywall, you will need to tape and finish it. This situation is similar to any other drywall repair project, you have at most five steps to complete the finishing. (1) Applying the drywall tape. (2) Installing a first coat of drywall compound. (3) After a light sanding, you will apply a second coat of compound. (4) After another light sanding, you will want to skim the drywall with a light coat of mud to smooth out the surface. (5) The last step is to sand the drywall to prepare it for a coat of paint.
For a complete discussion on the steps involved with a drywall finishing project, see the article, 'Taping and Mudding Drywall'