DCF Valuation: the gold standard for intrinsic value
Discounted Cash Flow (DCF) is the most theoretically sound valuation method. It values a company based on the present value of its future cash flows—money in hand today is worth more than money promised tomorrow.
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
Intrinsic Investor is for educational purposes only. Not financial advice.