DCF Model: Logic and Structure

Discounted Cash Flow as the basis of valuation
Discounted Cash Flow (DCF) is a fundamental approach to business valuation based on the principle that a company’s value equals the present value of its future cash flows. DCF is the "first principle" of valuation, from which other methods are derived.

Logic of DCF
Intrinsic value: DCF estimates intrinsic value—what a company is really worth based on its cash-generating ability. In contrast to market value (current price) or book value (accounting). Present value: future cash flows are discounted to today. $1 today > $1 tomorrow due to opportunity cost, risk, inflation. Fundamental equation: Value = Σ CFₜ / (1+r)ᵗ. Sum of all future cash flows discounted at appropriate rate.

Two DCF Approaches
FCFF/WACC approach: discount Free Cash Flow to Firm at WACC → Enterprise Value. Then subtract Net Debt → Equity Value. Most common approach. FCFE/Cost of Equity approach: discount Free Cash Flow to Equity at Cost of Equity → Equity Value directly. Equivalent result if consistent assumptions.

Consistency critical: FCFF (for all capital providers) with WACC (cost of all capital). FCFE (for equity) with Cost of Equity. Mixing is error.

DCF Structure
Step 1: Forecast FCFF (or FCFE) for explicit forecast period—typically 5-10 years. Step 2: Calculate Terminal Value—the value beyond the forecast period. Usually 60-80% of total value. Step 3: Discount FCF and Terminal Value to present using WACC (or Cost of Equity). Step 4: Sum = Enterprise Value. Subtract Net Debt, add cash = Equity Value. Divide by shares = per share value.

Forecast Period
Explicit period: project FCF year by year until company reaches "steady state"—stable growth, mature margins, normalized CAPEX. Length: 5 years is standard. 10 years for high-growth companies not yet at steady state. Beyond 10 years is rare—uncertainty too high. Detailed projections: revenue growth, margins, working capital, CAPEX. Each assumption based on analysis—historical trends, industry dynamics, management guidance.

Terminal Value
Captures value beyond the forecast period. Company is assumed to operate indefinitely at steady state.

Two methods:

• Gordon Growth Model (perpetuity formula)
• Exit Multiple approach

Terminal value often dominates: 60-80% of DCF value from terminal value. Critical to get right.

Gordon Growth Model
TV = FCF(n+1) / (WACC - g). Where FCF(n+1) is FCF in the first year after forecast period, g is perpetual growth rate. Growth rate (g): must be ≤ long-term economy growth (GDP + inflation). Typically 2-3% for a mature company. Higher is not sustainable indefinitely. FCF(n+1) = FCF(n) × (1+g). Assumes stable growth begins immediately after the forecast period.

Exit Multiple Approach
TV = EBITDA(n) × Exit Multiple. Value based on applying multiple to final year financials. Multiple selection: based on comparable companies' current multiples, or historical average. Implies perpetual growth assumption. Cross-check: implied growth rate from exit multiple. If multiple is 10x, WACC 10%, implied g = WACC - 1/Multiple = 10% - 10% = 0%. If multiple = 8x, implied g = 10% - 12.5% = negative (makes little sense).

Discount Rate Selection
WACC: weighted average cost of debt and equity. Reflects company's overall cost of capital. Cost of Equity: via CAPM (Rf + β × ERP) or alternative methods. Cost of Debt: yield on company's bonds or bank debt, after-tax. Target weights: use target capital structure for forward-looking analysis.

Enterprise Value to Equity Value
Enterprise Value: value of operating business = PV(FCF) + PV(Terminal Value). Equity Value = Enterprise Value - Net Debt + Non-operating Assets. Net Debt = Debt - Cash. Non-operating: excess cash, investments, unconsolidated subs. Per share value = Equity Value / Diluted Shares Outstanding. Account for options, convertibles.

DCF Advantages

• Fundamental: based on cash generation ability, not market sentiment or accounting policies.
• Flexible: can incorporate detailed projections, scenarios, sensitivities.
• Forward-looking: values future potential, not just current state.

DCF Limitations

• Sensitive to assumptions: small changes in growth, margin, WACC → large value changes. Terminal value particularly sensitive.
• "Garbage in, garbage out": quality depends on forecast quality. Biased forecasts → biased valuation.
• Not useful for: early-stage companies with negative cash flows and no visibility, distressed companies, companies undergoing significant changes.

Best Practices

• Sensitivity analysis: test key assumptions (growth, margin, WACC). Present range of values, not a single point.
• Scenario analysis: base case, bull case, bear case. Weight scenarios for expected value.
• Cross-check: compare DCF to trading multiples, transaction comps. Large discrepancy warrants investigation.
• Document assumptions: transparent about inputs. Allows challenge and refinement.