Module XII·Article II·~2 min read
DCF Step by Step: From Assumptions to Value
Financial Modeling
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The discounted cash flow (DCF) method is a fundamental approach to business valuation, based on the principle of the time value of money: an asset is worth the sum of its future cash flows, discounted at a rate that reflects its risk. DCF makes it possible to determine the intrinsic value—that is, a business valuation based on its fundamental characteristics, regardless of market sentiment.
Step 1: Forecast Free Cash Flow. FCF (Free Cash Flow to the Firm, FCFF) = EBIT × (1 − Tax Rate) + D&A − Capex − ΔWorking Capital. This is the cash flow available to all investors (both creditors and shareholders) before accounting for debt. Forecast period: typically 5–10 years, until the business reaches a "steady state." In the forecast period: a separate forecast for each line of the P&L and Balance Sheet. Revenue drivers: organic growth, new products, M&A. EBITDA margin: operating leverage, mix effect. Capex: Maintenance capex (asset upkeep) + Growth capex (expansion).
Step 2: Terminal Value. After the forecast period, the business continues to exist. Terminal Value reflects the value of all FCF after the forecast period. Two methods: Gordon Growth Model (Perpetuity Growth): TV = FCF₍n+1₎ / (WACC − g), where g is the long-term growth rate (usually 1–3%, corresponding to the long-term nominal GDP growth rate). Exit Multiple Method: TV = EBITDA₍n₎ × Exit Multiple. Cross-checking both methods is a mandatory practice. Terminal Value typically accounts for 60–80% of the final EV—this indicates high sensitivity to terminal value assumptions.
Step 3: WACC Calculation. WACC = Kd × (1−T) × D/V + Ke × E/V. Kd (cost of debt) = yield to maturity of the company’s debt obligations. Ke (cost of equity) = Rf + β × (ERP): Rf is the risk-free rate (yield on 10-year government bonds), β is market risk (levered beta = unlevered beta × [1 + (1−T) × D/E]), ERP (Equity Risk Premium) is the historical or implied premium. Capital Structure: market, not book, weights.
Step 4: Discounting and Bridge. PV(FCF) = FCF₁/(1+WACC)¹ + ... + FCFn/(1+WACC)^n + TV/(1+WACC)^n = Enterprise Value (EV). Bridge EV → Equity Value: EV − Net Debt − Minorities + Cash = Equity Value. Equity Value / Diluted Shares = Intrinsic Value per share. Sensitivity: a sensitivity table for WACC (±1%) and Terminal Growth Rate (±0.5%) is a required element of a professional DCF.
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