Financial Modeling & Valuation

Module 3: DCF Valuation

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Module Overview

The Discounted Cash Flow (DCF) analysis is the gold standard of intrinsic valuation. It values a company based on the present value of its expected future cash flows. Unlike market-based methods, DCF derives value from fundamentals—what the company actually generates.

In this module, you'll learn to build a complete DCF model, from calculating free cash flow to determining terminal value and deriving enterprise and equity value.

Learning Objectives:

By the end of this module, you will be able to:

• Calculate Free Cash Flow to Firm (FCFF) and Free Cash Flow to Equity (FCFE)
• Determine the Weighted Average Cost of Capital (WACC)
• Project cash flows using multiple methodologies
• Calculate terminal value using perpetuity growth and exit multiple methods
• Discount cash flows and arrive at enterprise value
• Bridge from enterprise value to equity value per share
• Build sensitivity tables for key assumptions

Estimated Time: 5-6 hours

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3.1 The DCF Framework

The Fundamental Principle

A company (or any asset) is worth the present value of all future cash flows it will generate.

The DCF Formula:

                   CF₁         CF₂         CF₃              CFₙ + TVₙ
Enterprise Value = ───────── + ───────── + ───────── + ... + ─────────
                  (1+r)¹     (1+r)²     (1+r)³           (1+r)ⁿ

Where:
  CF = Free Cash Flow in each period
  r = Discount Rate (WACC)
  TV = Terminal Value
  n = Number of projection periods

Why DCF?

Advantages:

• Based on intrinsic fundamentals, not market sentiment
• Forces you to think about cash flow drivers
• Not dependent on comparable companies existing
• Flexible—can model any scenario

Disadvantages:

• Highly sensitive to assumptions (especially WACC and terminal value)
• Requires forecasting the future (inherently uncertain)
• Terminal value often dominates the result
• Easy to manipulate to get any answer you want

Key Insight: DCF is powerful but dangerous. The precision of the numbers creates an illusion of accuracy. Always remember: your DCF is only as good as your assumptions.

DCF Structure

A typical DCF has these components:

1. Free Cash Flow Projections (Years 1-5 or 1-10)
2. Terminal Value (Value beyond projection period)
3. Discount Rate (WACC)
4. Present Value Calculation
5. Enterprise Value
6. Bridge to Equity Value
7. Implied Share Price
8. Sensitivity Analysis

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3.2 Free Cash Flow Calculation

Free Cash Flow to Firm (FCFF)

FCFF represents cash available to all capital providers (debt and equity holders):

FCFF = EBIT × (1 - Tax Rate) + D&A - CapEx - ΔNWC

Where:
  EBIT = Earnings Before Interest and Taxes (Operating Income)
  Tax Rate = Marginal tax rate
  D&A = Depreciation & Amortization
  CapEx = Capital Expenditures
  ΔNWC = Change in Net Working Capital

Why start with EBIT? We want cash available to all investors before interest payments. Starting with EBIT and taxing it directly gives us unlevered after-tax cash flow.

Alternative Formula:

FCFF = EBITDA × (1 - Tax Rate) + D&A × Tax Rate - CapEx - ΔNWC

Simplified:

FCFF = Net Income + Interest × (1 - Tax Rate) + D&A - CapEx - ΔNWC

Example FCFF Calculation

FCFF Calculation ($M)          2025E    2026E    2027E    2028E    2029E
────────────────────────────────────────────────────────────────────────
EBIT (Operating Income)          295      345      389      420      445
  × (1 - Tax Rate of 25%)      ×0.75    ×0.75    ×0.75    ×0.75    ×0.75
────────────────────────────────────────────────────────────────────────
NOPAT (After-Tax EBIT)           221      259      292      315      334

  + Depreciation & Amort.        125      137      148      155      162
  - Capital Expenditures        (124)    (128)    (130)    (140)    (145)
  - Change in NWC                (16)     (16)     (12)     (10)      (8)
────────────────────────────────────────────────────────────────────────
Free Cash Flow to Firm           206      252      298      320      343

Free Cash Flow to Equity (FCFE)

FCFE represents cash available to equity holders after debt service:

FCFE = Net Income + D&A - CapEx - ΔNWC - Net Debt Repayment

Where:
  Net Debt Repayment = Debt Repayment - New Debt Issuance

When to use FCFE:

• When valuing equity directly
• Discount at cost of equity (not WACC)
• Less common in practice

When to use FCFF:

• Standard approach for most DCF analyses
• Discount at WACC
• Preferred by investment bankers and analysts

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3.3 Weighted Average Cost of Capital (WACC)

What is WACC?

WACC is the blended cost of all capital (debt and equity) used to fund the business:

WACC = (E/V) × Ke + (D/V) × Kd × (1 - T)

Where:
  E = Market Value of Equity
  D = Market Value of Debt
  V = E + D (Total Capital)
  Ke = Cost of Equity
  Kd = Cost of Debt
  T = Tax Rate

Why tax-adjust debt? Interest payments are tax-deductible, reducing the effective cost of debt.

Cost of Equity (Ke)

The cost of equity is the return shareholders require. It's typically calculated using the Capital Asset Pricing Model (CAPM):

Ke = Rf + β × (Rm - Rf)

Where:
  Rf = Risk-Free Rate (typically 10-year Treasury yield)
  β = Beta (measure of stock volatility vs. market)
  Rm = Expected Market Return
  (Rm - Rf) = Equity Risk Premium (ERP)

Example:

Risk-Free Rate (Rf):           4.0%
Beta (β):                      1.2
Equity Risk Premium (ERP):     5.0%

Ke = 4.0% + 1.2 × 5.0%
   = 4.0% + 6.0%
   = 10.0%

Finding Beta

Options for Beta:

1. Levered Beta from data providers (Bloomberg, Capital IQ) - Most common

2. Unlevered Beta calculation:

   Unlevered β = Levered β / [1 + (1-T) × (D/E)]
   

   Then re-lever to your target capital structure

3. Industry Average Beta - Use when company-specific data is noisy

Beta Interpretation:

• β = 1.0: Moves with the market
• β > 1.0: More volatile than market (tech stocks, growth companies)
• β < 1.0: Less volatile than market (utilities, consumer staples)

Cost of Debt (Kd)

The cost of debt is the interest rate the company pays on its borrowings:

Options:

1. Current yield on existing bonds
2. Weighted average interest rate on all debt
3. Credit spread + Risk-free rate

Example:

If company's bonds yield 6.5%:
Kd = 6.5%

After-tax Cost of Debt = 6.5% × (1 - 25%) = 4.875%

Capital Structure Weights

Use market values, not book values:

Market Value of Equity (E) = Share Price × Shares Outstanding
Market Value of Debt (D) = Trading price of bonds (or approximate with book value)
Total Value (V) = E + D

Weight of Equity = E / V
Weight of Debt = D / V

Example WACC Calculation

Capital Structure:
  Market Value of Equity:       $1,500M
  Market Value of Debt:           $300M
  Total Capital:                $1,800M

Weights:
  Equity Weight (E/V):            83.3%
  Debt Weight (D/V):              16.7%

Costs:
  Cost of Equity (Ke):            10.0%
  Pre-Tax Cost of Debt (Kd):       6.0%
  Tax Rate:                        25%

WACC Calculation:
  WACC = (83.3% × 10.0%) + (16.7% × 6.0% × 0.75)
       = 8.33% + 0.75%
       = 9.08%

WACC Sensitivity

WACC has an enormous impact on DCF valuation:

WACC	Enterprise Value (Example)
7%	$5,200M
8%	$4,500M
9%	$4,000M
10%	$3,600M
11%	$3,250M

A 1% change in WACC can change value by 10-20%. Be thoughtful about this assumption.

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3.4 Terminal Value

Why Terminal Value?

You can't project cash flows forever. Terminal value captures the value of all cash flows beyond your projection period.

Typical approach:

• Project detailed cash flows for 5-10 years
• Calculate terminal value at end of projection period
• Terminal value often represents 50-80% of total value

Method 1: Perpetuity Growth Method (Gordon Growth Model)

Assume cash flows grow at a constant rate forever:

Terminal Value = FCF(n+1) / (WACC - g)

Where:
  FCF(n+1) = Free Cash Flow in year after projection period
  WACC = Discount rate
  g = Perpetual growth rate

Example:

Year 5 FCF:           $343M
Perpetual Growth (g):   2.5%
WACC:                   9.0%

Terminal Value = $343M × (1 + 2.5%) / (9.0% - 2.5%)
              = $352M / 6.5%
              = $5,412M

Choosing the Growth Rate:

• Should not exceed long-term GDP growth (typically 2-3%)
• Represents sustainable forever growth
• Higher than inflation, lower than current growth
• Common range: 1.5% - 3.0%

Sanity Check: The implied exit multiple from perpetuity growth should be reasonable:

Implied EV/EBITDA = Terminal Value / Terminal Year EBITDA

Method 2: Exit Multiple Method

Apply a valuation multiple to terminal year metric:

Terminal Value = Terminal Year EBITDA × Exit Multiple

or

Terminal Value = Terminal Year EBIT × Exit Multiple

Example:

Year 5 EBITDA:        $607M
Exit EV/EBITDA:       9.0×

Terminal Value = $607M × 9.0 = $5,463M

Choosing the Exit Multiple:

• Current trading multiple of company
• Average trading multiple of peers
• Historical average multiple
• Often 1-2 turns below current multiple (conservatism)

Sanity Check: Calculate the implied perpetual growth rate:

Implied g = WACC - (FCF / Terminal Value)

This should be reasonable (1-3%).

Which Method to Use?

Most practitioners use both and compare results:

Method	Terminal Value	Implied Check
Perpetuity Growth (2.5%)	$5,412M	Implied multiple: 8.9×
Exit Multiple (9.0×)	$5,463M	Implied growth: 2.6%

When the methods converge, you have more confidence in the result.

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3.5 Discounting and Enterprise Value

Present Value of Cash Flows

Each cash flow is discounted to present value:

PV of CF₁ = CF₁ / (1 + WACC)¹
PV of CF₂ = CF₂ / (1 + WACC)²
...and so on

Mid-Year Convention: Cash flows don't all arrive on December 31. The mid-year convention assumes they arrive mid-year:

PV of CF₁ = CF₁ / (1 + WACC)^0.5
PV of CF₂ = CF₂ / (1 + WACC)^1.5
...

This increases present values slightly (more realistic).

Example DCF Calculation

DCF Valuation ($M)            2025E    2026E    2027E    2028E    2029E    TV
──────────────────────────────────────────────────────────────────────────────
Free Cash Flow                  206      252      298      320      343
Terminal Value                                                          5,412

Discount Period (mid-year)      0.5      1.5      2.5      3.5      4.5      4.5
Discount Factor (@ 9.0%)      0.958    0.878    0.806    0.739    0.678    0.678

Present Value of FCF            197      221      240      237      233
Present Value of TV                                                     3,669

Sum of PV of FCFs           $1,128M
PV of Terminal Value        $3,669M
──────────────────────────────────────────────────────────────────────────────
Enterprise Value            $4,797M

% from Projection Period:       24%
% from Terminal Value:          76%

Notice: 76% of value comes from terminal value. This is why terminal value assumptions are so critical.

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3.6 From Enterprise Value to Share Price

The Bridge

Enterprise Value represents the value of the entire business. To get to equity value per share:

Enterprise Value
  - Total Debt
  + Cash
  - Preferred Stock
  - Minority Interest
  + Equity Investments (if valued separately)
─────────────────────────────────────────
= Equity Value

Equity Value / Shares Outstanding = Implied Share Price

Example Bridge

Bridge to Equity Value ($M)
──────────────────────────────────────────
Enterprise Value                    $4,797
  - Total Debt                       (300)
  + Cash                              195
  - Preferred Stock                     0
  - Minority Interest                   0
──────────────────────────────────────────
Equity Value                        $4,692

Shares Outstanding (M):               100
──────────────────────────────────────────
Implied Share Price                 $46.92

Current Share Price                 $45.00
Upside/(Downside)                    +4.3%

Interpreting the Result

• If Implied Price > Current Price: Stock may be undervalued
• If Implied Price < Current Price: Stock may be overvalued

But remember: Your DCF is only as good as your assumptions. The market might know something you don't.

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3.7 Sensitivity Analysis

Why Sensitivity Matters

DCF valuations are highly sensitive to assumptions. Professional analysts always present sensitivities to key inputs:

1. WACC - Discount rate
2. Terminal Growth Rate - Perpetual growth
3. Exit Multiple - Terminal multiple
4. Revenue Growth - Near-term driver
5. Operating Margin - Profitability assumption

Two-Way Sensitivity Table

The standard format shows how value changes with two variables:

Implied Share Price ($)
                        Terminal Growth Rate
                    1.5%    2.0%    2.5%    3.0%    3.5%
         ──────────────────────────────────────────────────
         7.5%      $58.23  $62.15  $66.73  $72.21  $78.93
  W      8.0%      $52.45  $55.67  $59.34  $63.63  $68.74
  A      8.5%      $47.56  $50.25  $53.28  $56.73  $60.72
  C      9.0%      $43.36  $45.63  $48.17  $50.58  $54.39
  C      9.5%      $39.72  $41.65  $43.78  $46.15  $48.83
        10.0%      $36.54  $38.19  $40.01  $41.88  $44.40

Reading the table:

• Current assumptions: WACC 9.0%, Terminal Growth 2.5% → $48.17
• Best case: Lower WACC, higher growth → $78.93
• Worst case: Higher WACC, lower growth → $36.54

Creating Sensitivity Tables in Excel

Using Data Tables:

1. Set up your two-way table with row and column inputs
2. In the corner cell, reference your output (share price)
3. Select the entire table
4. Data → What-If Analysis → Data Table
5. Row input cell: WACC assumption
6. Column input cell: Terminal growth assumption

This automatically calculates all combinations.

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3.8 DCF Best Practices

Model Structure

DCF Tab Structure:
1. Summary Outputs (at top)
2. FCF Calculation
3. WACC Calculation
4. Terminal Value (both methods)
5. Present Value Calculation
6. Enterprise Value Bridge
7. Sensitivity Tables

Common Mistakes to Avoid

1. Mixing FCFF and FCFE

• FCFF is discounted at WACC → Enterprise Value
• FCFE is discounted at Ke → Equity Value
• Never mix them

2. Double-Counting Cash in Terminal Value If you're using exit multiples, make sure the multiple is applied consistently (EV/EBITDA gives EV, not Equity Value).

3. Inconsistent Assumptions

• If revenue grows at 15% but terminal growth is 2.5%, the model should show deceleration
• Sudden jumps to terminal value without transition are unrealistic

4. Unrealistic Terminal Growth

• Never exceed long-term GDP growth (2-3%)
• Higher implies the company becomes the entire economy

5. Forgetting the Mid-Year Convention Standard practice; makes valuations more accurate.

6. Not Sense-Checking Results

• Compare to current trading price
• Calculate implied multiples
• Benchmark against peers

Professional Tips

1. Show Multiple Scenarios Present base, upside, and downside cases, not just one number.

2. Weight Terminal Value Methods Some analysts average perpetuity growth and exit multiple results.

3. Use Ranges Instead of "$46.92," present "$42-52" to acknowledge uncertainty.

4. Document Assumptions Explain why you chose each assumption. "WACC of 9.0% based on peer median beta of 1.1, 10-year Treasury of 4.0%, and 5.0% ERP."

5. Sensitivity Drives Decisions The sensitivity table often tells you more than the point estimate. What assumptions would change your recommendation?

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3.9 Practical Exercise: Build a DCF Model

Exercise Instructions

Using the 3-statement model from Module 2, build a complete DCF:

Given Assumptions:

WACC Inputs:
  Risk-Free Rate: 4.0%
  Beta: 1.15
  Equity Risk Premium: 5.0%
  Cost of Debt: 6.0%
  Tax Rate: 25%
  Target Debt/Total Capital: 15%

Terminal Value:
  Perpetual Growth Rate: 2.5%
  Exit EV/EBITDA Multiple: 8.5×

Capital Structure:
  Shares Outstanding: 100M
  Current Debt: $300M
  Current Cash: $195M

Your Task:

1. Calculate Cost of Equity using CAPM
2. Calculate WACC
3. Project Free Cash Flows for 5 years
4. Calculate Terminal Value (both methods)
5. Discount to present value (use mid-year convention)
6. Calculate Enterprise Value
7. Bridge to Equity Value and share price
8. Build WACC vs. Terminal Growth sensitivity table

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3.10 Key Takeaways

Free Cash Flow

FCFF = NOPAT + D&A - CapEx - ΔNWC
NOPAT = EBIT × (1 - Tax Rate)

FCFF is discounted at WACC to get Enterprise Value.

WACC

WACC = (E/V) × Ke + (D/V) × Kd × (1-T)
Ke = Rf + β × (Rm - Rf)

Use market value weights and be thoughtful about each input.

Terminal Value

• Perpetuity Growth: FCF(n+1) / (WACC - g)
• Exit Multiple: Terminal EBITDA × Multiple
• Use both methods and check for convergence.

Enterprise to Equity Bridge

Equity Value = Enterprise Value - Debt + Cash
Share Price = Equity Value / Shares Outstanding

Sensitivity DCF is only as good as assumptions. Always show sensitivity to WACC and terminal value.

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Looking Ahead to Module 4

DCF gives you intrinsic value—what the company should be worth based on fundamentals.

In Module 4, you'll learn Comparable Company Analysis (Trading Comps)—what the market is paying for similar companies. Together, DCF and Comps provide a comprehensive valuation picture.

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Summary

Congratulations on completing Module 3! You can now:

• Calculate Free Cash Flow to Firm (FCFF)
• Determine WACC using CAPM and capital structure weights
• Calculate terminal value using perpetuity growth and exit multiple methods
• Discount cash flows and terminal value to present
• Bridge from Enterprise Value to Equity Value per share
• Build and interpret sensitivity tables

DCF is the most theoretically rigorous valuation method. Combined with market-based approaches, you'll have a complete valuation toolkit.

Ready for market comparisons? Proceed to Module 4: Comparable Company Analysis to learn how the market values similar companies.

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"Valuation is not just about numbers—it's about judgment wrapped in a spreadsheet." — Anonymous Wall Street Analyst