Introduction to DCF Valuation

DCF (Discounted Cash Flow) estimates the intrinsic value of a business by projecting the cash it will generate and discounting those cash flows back to today.

What you'll learn

The logic behind DCF and why money today is worth more than money tomorrow
The difference between FCFF (to the firm) and FCFE (to equity) and when to use each
How to estimate the discount rate using WACC and CAPM
Two ways to estimate terminal value: Gordon growth and exit multiple
Step-by-step calculation of a complete DCF with numbers
How to run sensitivity and scenario analyses and interpret results
Practical ways to use DCF in buy/sell decisions and risk assessment

Concept explanation

At its core, DCF asks a simple question: if you owned the entire business, how much cash would it put in your pocket over time, and what is that stream worth today? Because a dollar in the future is less valuable than a dollar today, we "discount" future cash flows back to present value using a rate that reflects risk and opportunity cost.

DCF can be built on two cash flow definitions. Free Cash Flow to the Firm (FCFF) is the cash available to all capital providers (both debt and equity) after funding operations and investments. Discount FCFF at the Weighted Average Cost of Capital (WACC) to get the enterprise value, then subtract net debt to arrive at equity value. Free Cash Flow to Equity (FCFE) is the cash left just for equity holders after interest and net borrowing; discount FCFE at the cost of equity to get equity value directly.

The model has two parts: an explicit forecast period, where you project cash flows year by year, and a terminal value, which captures all cash flows beyond the forecast horizon. The terminal value is often the largest piece of a DCF, so care and conservatism are crucial.

Why it matters

DCF is valuation from first principles. It does not rely on what peers trade at or the current mood of the market. Instead, it ties value to the business’s ability to produce cash, which ultimately funds dividends, buybacks, and debt repayment. For investors, this can provide an anchor when prices swing with sentiment.

However, DCF is sensitive to assumptions. Small changes in growth, margins, or the discount rate can move the valuation meaningfully. That’s not a flaw; it’s feedback. By testing assumptions, you learn which drivers matter most and where you need conviction or a margin of safety.

DCF is especially useful when: a company has a clear path to positive free cash flow; growth and return profiles differ from peers; or comparable companies are scarce. It’s less useful if the business model is still experimental, cash flows are highly volatile, or capital needs are unpredictable.

Calculation method

Key formulas

Present value of a cash flow:

PV = \dfrac{CF_t}{(1 + r)^t}

Enterprise value using FCFF and WACC:

EV = \sum_{t=1}^{N} \dfrac{FCFF_t}{(1 + WACC)^t} + \dfrac{TV_N}{(1 + WACC)^N}

Equity value from EV:

Equity\ Value = EV - Net\ Debt + Non\!\-operating\ Assets

FCFF and FCFE (one common formulation):

FCFF = EBIT \times (1 - Tax\ Rate) + Depreciation\ \&\ Amortization - CapEx - \Delta Working\ Capital FCFE = Net\ Income + Depreciation\ \&\ Amortization - CapEx - \Delta Working\ Capital + Net\ Borrowing

WACC:

WACC = \dfrac{E}{D + E} \cdot R_e + \dfrac{D}{D + E} \cdot R_d \cdot (1 - Tax\ Rate)

Cost of equity (CAPM):

R_e = R_f + \beta \cdot (Market\ Risk\ Premium)

Terminal value (Gordon growth):

TV_N = \dfrac{FCFF_{N+1}}{WACC - g}

Terminal value (exit multiple on EBITDA as an example):

TV_N = EBITDA_N \times Exit\ Multiple

Step-by-step process

Choose FCFF or FCFE. If capital structure may change or you want enterprise value, use FCFF. If you only care about equity and leverage is stable, FCFE can be fine.
Forecast operating drivers for 5 to 10 years: revenue growth, operating margins, tax rate, CapEx, working capital needs, and depreciation. Turn these into FCFF or FCFE each year.
Estimate the discount rate. For FCFF, compute WACC using target capital structure, cost of debt after tax, and cost of equity via CAPM. For FCFE, use cost of equity.
Estimate terminal value. If the business is mature or will be, the Gordon growth model is appropriate with a conservative perpetual growth rate not exceeding long-run nominal GDP growth. For deal or market-centric industries, an exit multiple triangulated from comparable mature companies can be used, but recognize it reintroduces market sentiment.
Discount all cash flows and the terminal value back to today and sum the present values.
Move from enterprise value to equity value: subtract net debt and adjust for non-operating assets or liabilities.
Divide by shares outstanding to get intrinsic value per share. Compare with the market price.

Mini examples

Present value: A 100 cash flow received in 3 years at a 10% discount rate is 100 / (1.10^3) ≈ 75.13.
Gordon growth: If the last forecast FCFF is 120 and you expect 3% perpetual growth with 9% WACC, next-year FCFF is 120 × 1.03 = 123.6. Terminal value at year N is 123.6 / (0.09 − 0.03) = 2,060.

Case study

Suppose you are valuing AlphaCo, a stable, asset-light software company with recurring revenue. You choose FCFF because you want enterprise value and leverage may change.

Assumptions:

Revenue growth slows from 12% to 6% over 5 years; operating margin stabilizes at 25%.
Tax rate: 22%. Depreciation roughly equals 60% of CapEx. Working capital is modest, increasing by 1% of revenue annually.
Capital expenditures (CapEx): starts at 8% of revenue and trends to 6% by year 5.
WACC: 9%. Perpetual growth after year 5: 2.5%.
Net debt: 200. Shares outstanding: 50.

Year 1-5 projections (simplified, in millions):

Year 0 revenue base: 1,000.
Revenue: 1,120; 1,230; 1,321; 1,400; 1,484 (approximate rounding).
EBIT at 25% margin by Year 5; ramping from 22% in Year 1 to 25% in Year 5: EBIT ≈ 246; 287; 317; 336; 371.
NOPAT = EBIT × (1 − Tax) ≈ 192; 224; 247; 262; 289.
Depreciation (D&A): assume 60% of CapEx; CapEx as % of revenue trends from 8% to 6%: CapEx ≈ 89.6; 92.3; 92.5; 84.0; 89.0. D&A ≈ 53.8; 55.4; 55.5; 50.4; 53.4.
Change in working capital (ΔWC): 1% of annual revenue change: ΔWC ≈ 1.2; 1.1; 0.9; 0.8; 0.8.

Compute FCFF each year:

FCFF_t = NOPAT_t + D\&A_t - CapEx_t - \Delta WC_t

Year 1 FCFF ≈ 192 + 53.8 − 89.6 − 1.2 = 155.0
Year 2 FCFF ≈ 224 + 55.4 − 92.3 − 1.1 = 186.0
Year 3 FCFF ≈ 247 + 55.5 − 92.5 − 0.9 = 209.1
Year 4 FCFF ≈ 262 + 50.4 − 84.0 − 0.8 = 227.6
Year 5 FCFF ≈ 289 + 53.4 − 89.0 − 0.8 = 252.6

Terminal value using Gordon growth (with FCFF growing at 2.5% beyond Year 5):

Year 6 FCFF = 252.6 × 1.025 = 258.9

TV_5 = \dfrac{FCFF_6}{WACC - g} = \dfrac{258.9}{0.09 - 0.025} = 3,983.1

Discount the cash flows and terminal value at 9% back to today:

PV Year 1 = 155.0 / 1.09^1 = 142.2
PV Year 2 = 186.0 / 1.09^2 = 156.6
PV Year 3 = 209.1 / 1.09^3 = 161.5
PV Year 4 = 227.6 / 1.09^4 = 161.4
PV Year 5 = 252.6 / 1.09^5 = 164.0
PV of TV = 3,983.1 / 1.09^5 = 2,589.6

Sum of PVs (enterprise value): 142.2 + 156.6 + 161.5 + 161.4 + 164.0 + 2,589.6 = 3,375.3

Equity bridge and per-share value:

Equity value = EV − Net Debt = 3,375.3 − 200 = 3,175.3
Intrinsic value per share = 3,175.3 / 50 = 63.5

Interpretation: If the market price is 50, AlphaCo appears undervalued relative to this base-case DCF. However, the result depends heavily on WACC and terminal growth. Sensitivity is essential.

Practical applications

Buy/sell decisions: Compare intrinsic value per share to the market price. If the price is meaningfully below your conservative DCF value, you may have a margin of safety.
Sensitivity analysis: Vary WACC and terminal growth in a grid to see valuation ranges. For example, changing WACC from 8% to 10% might swing value per share by 15 to 25%. Focus research on the assumptions that move value the most.
Scenario analysis: Build bear/base/bull cases by adjusting growth, margins, and reinvestment (CapEx and ΔWC). Assign subjective probabilities to understand expected value and downside risk.
Capital allocation insights: DCF exposes the link between growth and reinvestment. A company with high returns on invested capital can grow value efficiently; if returns fade, growth may destroy value.
Cross-check with multiples: After running DCF, translate your valuation into implied EV/EBITDA or P/E using your Year N metrics. If your implied multiples are extreme versus peers, revisit assumptions.
Cycle-aware investing: For cyclicals, normalize mid-cycle margins and reinvestment to avoid overvaluing peak earnings. For high growth, lengthen the forecast but taper growth and assume competitive pressure.
Financing considerations: If leverage will change, prefer FCFF with a target capital structure to avoid double-counting debt effects.

Use conservative terminal growth (often within 1.5% to 3%) and test multiple WACC inputs. The terminal value should not dominate due to aggressive assumptions.

Common misconceptions

よくある誤解

- DCF gives a single "true" number. In reality, it yields a range based on assumptions; treat it as a decision tool, not an oracle. - Higher growth always increases value. Not if reinvestment needs are high or returns on new capital are low; growth can destroy value. - WACC is the current capital structure. Use a target, sustainable mix of debt and equity, not a transient snapshot. - Exit multiples are easier, so use them for terminal value without checks. Multiples embed market mood; always cross-check with a Gordon growth result. - Negative near-term cash flow makes DCF impossible. You can still model a path to profitability; just ensure assumptions are grounded and include sufficient runway.

Summary

まとめ

- DCF values a business by discounting future free cash flows back to present value. - Use FCFF with WACC for enterprise value; subtract net debt to reach equity value. - Forecast operating drivers, then compute FCFF or FCFE year by year. - Estimate discount rates via CAPM for equity and blend into WACC using target structure. - Choose terminal value via Gordon growth with conservative long-run growth or an exit multiple cross-check. - Discount, sum, adjust for net debt, and divide by shares to get value per share. - Run sensitivity and scenario analyses to understand key drivers and maintain a margin of safety.

Glossary

Discounted Cash Flow (DCF): A valuation method that estimates intrinsic value by discounting projected future cash flows to present value.

Free Cash Flow (FCF): Cash generated by a company after funding operations and necessary investments; can be defined for the firm (FCFF) or for equity (FCFE).

FCFF: Free Cash Flow to the Firm; cash available to both debt and equity holders, discounted at WACC to get enterprise value.

FCFE: Free Cash Flow to Equity; cash available to equity holders after interest and net borrowing, discounted at the cost of equity.

WACC: Weighted Average Cost of Capital; the blended required return from debt and equity providers.

CAPM: Capital Asset Pricing Model; estimates the cost of equity as risk-free rate plus beta times market risk premium.

Terminal Value: The value of all cash flows beyond the explicit forecast period in a DCF, often estimated by Gordon growth or an exit multiple.

Net Debt: Total debt minus cash and cash equivalents; subtracted from enterprise value to reach equity value.

FreeCashFlow: Cash generated after operating expenses and investments, used as the core input for DCF valuation.