DCF Valuation: the gold standard for intrinsic value

The Basic Formula

DCF = Σ (FCF / (1 + r)^t) + Terminal Value / (1 + r)^n

• FCF = Free Cash Flow (cash generated after capital expenditures)
• r = Discount rate (typically WACC for enterprise value)
• t = Time period (year 1, 2, 3, etc.)
• Terminal Value = Value of all cash flows beyond the forecast period

Step 1: Forecast Free Cash Flow

Project FCF for 5-10 years based on revenue growth, margins, and capital needs. Be conservative— it's better to underestimate than overestimate.

Step 2: Calculate the Discount Rate (WACC)

WACC (Weighted Average Cost of Capital) reflects the company's cost of funding. It combines:

• Cost of equity (using CAPM: Risk-free rate + Beta × Market risk premium)
• Cost of debt (interest rate × (1 - tax rate))

Step 3: Calculate Terminal Value

Terminal value captures all cash flows beyond your forecast period. Two common methods:

• Gordon Growth: FCF × (1 + g) / (WACC - g), where g is perpetual growth (2-3%)
• Exit Multiple: Final year EBITDA × Industry multiple

Common Mistakes

• Using overly optimistic growth rates
• Forgetting to subtract net debt to get equity value
• Using the wrong discount rate (WACC vs. cost of equity)
• Not sensitivity-testing your assumptions