DCF: Theory and Mechanics

A DCF (Discounted Cash Flow) model is the most principled way to value a business. The idea is simple: a company is worth the present value of all the cash it will ever generate for its owners. You estimate future free cash flows, choose a discount rate that reflects the riskiness of those cash flows, and discount them back to today.

This sounds straightforward but involves dozens of assumptions, revenue growth, margins, capex intensity, working capital, terminal growth rate, and WACC. Because the terminal value (the value beyond the explicit forecast period) typically represents 60–80% of total value, the model is enormously sensitive to that single assumption.

DCF is best used not to arrive at a single precise number, but to understand the implied assumptions of the current market price and to stress-test scenarios. When a stock is trading at a price that requires heroic growth assumptions to justify in a DCF, that's informative even if you never know the "right" intrinsic value.

Two approaches: FCFF and FCFE

Free Cash Flow to Firm (FCFF): cash available to all capital providers: FCFF = EBIT × (1 − t) + D&A − Capex − ΔWCE (ΔWCE = change in operating working capital) Discount FCFF at WACC. Subtract net debt to get equity value.

Free Cash Flow to Equity (FCFE): cash available to equity holders: FCFE = PAT + D&A − Capex − ΔWCE − Debt Repayment + New Borrowings Discount FCFE at cost of equity (Ke). Gives equity value directly.

Building the model:

1. Forecast revenue (volume × price, or segment-by-segment)
2. Project margins → EBIT
3. Compute FCFF for each year (typically 5–10 years explicit forecast)
4. Calculate Terminal Value:
   • Gordon Growth: TV = FCFF_{n+1} ÷ (WACC − g)
   • Exit Multiple: TV = EBITDA_n × EV/EBITDA multiple
5. Discount all cash flows + TV at WACC
6. Add non-operating assets, subtract net debt → Equity Value → divide by shares → intrinsic value per share

Sensitivity table: Always output a WACC vs terminal growth rate sensitivity table. Value estimates should span a range, not a single number.