DCF Valuation GUIDE

This is your ultimate reference for performing a Discounted Cash Flow (DCF) valuation with precision and clarity. Whether you’re an investor, analyst, or finance enthusiast, this guide distills the process into its core components for maximum understanding and application.

What is DCF Valuation?

Discounted Cash Flow (DCF) valuation is a method used to estimate the intrinsic value of an asset, business, or investment based on its projected future cash flows. By discounting these cash flows to their present value, you determine what the asset is worth today, accounting for the time value of money.

Key Components

Free Cash Flow (FCF): Cash generated by the business after covering operating expenses and investments.
Discount Rate (WACC): Reflects the required return on investment; often the Weighted Average Cost of Capital.
Projection Period: The time frame (5-10 years) over which future cash flows are forecasted.
Terminal Value (TV): Represents the business’s value after the projection period.

Step-by-Step Process

Step 1: Gather Input Data

Free Cash Flow (FCF):

Calculate historical FCF and use it as the baseline for projections:

FCF = Operating Cash Flow - Capital Expenditures

Discount Rate (WACC):

Use the formula to calculate the Weighted Average Cost of Capital:

WACC = (E/V) * Re + (D/V) * Rd * (1 - Tc)

Where:

E = Market value of equity
D = Market value of debt
V = Total value (equity + debt)
Re = Cost of equity
Rd = Cost of debt
Tc = Corporate tax rate

Growth Rates:

Estimate growth rates for cash flows and terminal value based on historical data, industry averages, and macroeconomic trends.

Step 2: Project Free Cash Flows

Project FCF for each year in the chosen horizon:

Projected FCF = Last Year’s FCF * (1 + Growth Rate)

Adjust growth rates over time to reflect maturity.
Typically, use higher growth in the early years, tapering off as the business stabilizes.

Step 3: Calculate Terminal Value

Use the Gordon Growth Model to estimate the value of cash flows beyond the projection period:

Terminal Value = (Final Year FCF * (1 + Terminal Growth Rate)) / (WACC - Terminal Growth Rate)

Important: Keep the terminal growth rate conservative (2-3%) to avoid overestimation.

Step 4: Discount Future Cash Flows to Present Value

Each future cash flow and the terminal value must be discounted to present value using the formula:

PV = Cash Flow / (1 + WACC)^n

Where:

n = Year of the cash flow (1, 2, 3, etc.)

Sum the present values of all projected FCFs and the terminal value:

Enterprise Value = Sum of Discounted FCFs + Discounted Terminal Value

Step 5: Adjust for Debt and Calculate Per-Share Value

Subtract Net Debt:

Equity Value = Enterprise Value - Net Debt

Net Debt = Total Debt – Cash

Calculate Per-Share Value:

Per-Share Value = Equity Value / Shares Outstanding

Example Calculation

Assumptions:

FCF (current): $100M
Growth Rate: 5%
WACC: 10%
Terminal Growth Rate: 3%
Projection Period: 5 years
Net Debt: $50M
Shares Outstanding: 10M

Steps:

Project FCFs:
- Year 1: $100M × (1 + 5%) = $105M
- Year 2: $105M × (1 + 5%) = $110.25M
- Repeat for Years 3-5.
Calculate Terminal Value:

TV = ($127.63M × (1 + 3%)) / (10% - 3%) = $1,887M

Discount Values:
- Discount each FCF and terminal value to present value using WACC.
Calculate Intrinsic Value:

Enterprise Value = Sum of PVs = $1,500M
Equity Value = $1,500M - $50M = $1,450M
Per-Share Value = $1,450M / 10M = $145/share

Key Considerations

Sensitivity Analysis:
- Test different WACC, growth rates, and terminal rates to understand valuation range.
Market Context:
- Align assumptions with industry trends and the economic environment.
Cross-Validation:
- Use comparable valuation methods (e.g., P/E multiples) to validate results.

Thank you!