Module XVIII·Article I·~3 min read
DCF Model
Practical Analytics and Tools
Turn this article into a podcast
Pick voices, format, length — AI generates the audio
DCF: Fundamental Company Valuation
Discounted Cash Flow (DCF) is a method of valuing a company based on the present value of future cash flows. DCF is considered the “gold standard” of fundamental analysis, although it has substantial limitations.
Philosophy of DCF
A company is worth as much as the money it will bring to its owners in the future, recalculated to today taking into account the cost of capital.
DCF Formula
Enterprise Value = Σ [FCFt / (1+WACC)^t] + TV / (1+WACC)^n
| Component | Description |
|---|---|
| FCF | Free Cash Flow |
| WACC | Weighted Average Cost of Capital — discount rate |
| TV | Terminal Value — value after forecast period |
| n | Length of forecast period (usually 5-10 years) |
Free Cash Flow Calculation
FCF = EBIT × (1-Tax) + Depreciation - CapEx - ΔNWC
| Component | Source | Comment |
|---|---|---|
| EBIT | Income Statement | Operating profit |
| Tax | Effective tax rate | ~25% typical |
| Depreciation | Cash Flow Statement | Non-cash expense (add back) |
| CapEx | Cash Flow Statement | Investment in fixed assets |
| ΔNWC | Balance Sheet | Change in net working capital |
Terminal Value: Two Methods
| Method | Formula | Application |
|---|---|---|
| Gordon Growth | TV = FCF(n+1) / (WACC - g) | Stable companies |
| Exit Multiple | TV = EBITDA(n) × EV/EBITDA | Comparative valuation |
Important: TV often constitutes 60-80% of total value → critically sensitive to assumptions.
DCF Example
| Year | FCF ($M) | Discount Factor (10%) | PV ($M) |
|---|---|---|---|
| 1 | 100 | 0.909 | 90.9 |
| 2 | 110 | 0.826 | 90.9 |
| 3 | 121 | 0.751 | 90.9 |
| 4 | 133 | 0.683 | 90.8 |
| 5 | 146 | 0.621 | 90.7 |
Sum of FCF PV: 454
TV (g=3%, WACC=10%): $146×1.03/(0.10-0.03) = 2,148$
PV of TV: $2,148 × 0.621 = 1,334$
Enterprise Value: 1,788
From Enterprise Value to Equity Value
Equity Value = EV - Net Debt + Non-operating Assets
Share Price = Equity Value / Shares Outstanding
DCF Sensitivity
Changes in key assumptions dramatically affect the result:
| WACC 9% | WACC 10% | WACC 11% | |
|---|---|---|---|
| g = 2% | $95 | $80 | $68 |
| g = 3% | $115 | $95 | $80 |
| g = 4% | $145 | $115 | $95 |
Conclusion:
Changing WACC by 1% or g by 1% can alter the valuation by 20-30%!
Limitations of DCF
- Garbage in = garbage out — quality depends on assumptions
- TV dominance — majority of value in terminal value
- WACC estimation — difficult to calculate accurately
- Doesn’t work for unprofitable businesses — negative cash flows = problem
- Ignores optionality — does not account for management flexibility
CIO Recommendations
- Use sensitivity tables — never just one number
- Cross-check with multiples — DCF + comparables
- Conservative assumptions — bias towards caution
- Margin of safety — buy only with 20-30% discount
- Understand the business — DCF is garbage if you don’t understand cash flows
§ Act · what next