Introduction
I'm going to teach you a fancy, yet tricky technique when not executed properly. But when done correctly, it will make your flag look super realistic.
See, what it does is use the image of silk or fabric as a displacement-map. That way the boring flag-image will just fold like the silk.

The Silk
I'm using silk because it's nice and soft and almost textureless. The only minor texture is the VERY soft silk-texture that's barely visible.
I got this stock from sxc.hu. But you can use any texture. I just chose silk because I like the shine and texture on it. It resembles the soft texture flags are made of. Grab your image of the texture and start working!

Press CTRL+SHIFT+U which will desaturate the image. We need this to be in black and white! Now because the displacement-filter is calcutaing it's displacement based on blacks and whites in the image, we want to increase the contrast. Do that by pressing CTRL+L.
Now place the sliders closer to each other and make sure it's not too light and not too dark. What we do want is the deepest color of Black and the deepest color of White in the image visible.
As I said, this extreme contrast is needed. Trust me, it will look great!

Now you should have only 1 layer in your document. Save it as a .psd-file and name it "map". Also don't forget where you save it!
With this done, press CTRL+Z untill you have the normal desaturated version of your texture. At this point, do not press Save anymore.

The Flag
Open a new layer above the silk-texture and paste or draw your flag in it. Since I'm from Holland, I used the Dutch flag, but you can use your own flag as well. Just search on google for the image of your countries flag.

Paste in your flag-image as shown above and drag the silk-texture above the flag and set the silk-texture to MULTIPLY and lower the opacity slightly.
This will overlap the flag and give it some depth and some shadow. Right now it actually looks real. Except for the part where the flag itself is not in motion. That's what we're gonna do next!

Distortion
Click on the flag-layer and go to Filter>Distort>Displace and a window will pop up. Set the horizontal and the vertical scale to 10% and make sure your settings are the same as mine below. When you press OK another window will pop up.
Remember that PSD we made earlier? This is the time to select it. When you press OK once more, you'll notice that your flag is actually distorted!


And you can do this with any flag. Below I have the flag of the United States just to show you how it works on a flag with a little more detail. But, you can also lower the horizontal and vertical scale to 8 or 5 if you want a lower distortion like the image below this one:


Conclusion
Now apart from the distortion and getting the PSD right, there's not much to worry. I enclosed my PSD above just in case yours doesn't work. Feel free to inspect it if you have problems.
Just make sure your levels are nice and crisp and very high on contrast. Nothing should go wrong then. Also just for kicks play around with the horizontal scale and the vertical scale to see what it does. Good Luck!
And as I said before, just google for more flags and you can make a whole army of flags. Note that also different textures will create different outcomes.