DCF Valuation

name: dcf-valuation description: DCF valuation methodology — WACC, terminal value, sensitivity

When to Activate

• User asks to value a company using intrinsic/fundamental methods
• Building a discounted cash flow model from scratch or reviewing one
• Calculating WACC, terminal value, or equity value per share
• Performing sensitivity or scenario analysis on a valuation
• Preparing a valuation section for a pitch book or fairness opinion

Core Concepts

Unlevered Free Cash Flow (UFCF)

UFCF represents cash available to all capital providers before debt service.

Formula:

UFCF = EBIT × (1 - Tax Rate)
     + Depreciation & Amortization
     - Capital Expenditures
     - Change in Net Working Capital

Key adjustments:

• Exclude interest expense (already captured in WACC)
• Normalize one-time items (restructuring, litigation, asset sales)
• Stock-based compensation: deduct as real economic cost (do NOT add back)
• Capitalize operating leases if pre-IFRS 16 financials
• Deferred revenue changes flow through working capital

Projection Period

• Typically 5-10 years; use 10 for high-growth or cyclical businesses
• Year 1-2: granular, driver-based (revenue by segment, gross margin, opex line items)
• Year 3-5: converge toward steady-state margins and growth
• Terminal year must reflect sustainable economics — no supernormal growth

WACC Calculation

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

Cost of Equity (Ke) via CAPM:

Ke = Rf + β × (Rm - Rf) + Size Premium + Country Risk Premium

Cost of Debt (Kd):

• Use yield-to-maturity on existing debt, not coupon rate
• If no public debt, use synthetic rating approach (interest coverage → rating → spread)
• Always use after-tax cost: Kd × (1 - t)

Capital Structure Weights:

• Use target or optimal capital structure, not current book values
• Market value of equity = share price × diluted shares outstanding
• Market value of debt = book value (unless distressed or materially mispriced)

Terminal Value

Gordon Growth Model (preferred for stable businesses):

TV = UFCFn × (1 + g) / (WACC - g)

• Terminal growth rate (g): 1.5-3.0% for developed markets (should not exceed long-run GDP growth)
• Ensure terminal year capex ≈ depreciation (steady state)

Exit Multiple Method (cross-check):

TV = EBITDAn × Exit Multiple

• Exit multiple based on current trading comps (not peak-cycle)
• Common to use slightly lower multiple than current to reflect maturity

Terminal value typically represents 60-80% of enterprise value — this is normal but warrants sensitivity testing.

Discount Factor and Present Value

Discount Factor = 1 / (1 + WACC)^n

• Use mid-year convention for businesses with evenly distributed cash flows
• Mid-year factor: 1 / (1 + WACC)^(n - 0.5)

Equity Bridge

Enterprise Value (sum of PV of FCFs + PV of TV)
- Net Debt (total debt - cash & equivalents)
- Minority Interest (at market value)
- Preferred Stock
- Unfunded Pension Obligations
+ Equity Method Investments (at fair value)
= Equity Value
÷ Diluted Shares Outstanding (treasury stock method)
= Equity Value Per Share

Methodology

Step-by-Step DCF Process

1. Gather historical financials — minimum 3-5 years of income statement, balance sheet, cash flow statement
2. Normalize historical performance — strip out non-recurring items, adjust for acquisitions
3. Build revenue model — segment-level drivers (volume × price, same-store × new store, etc.)
4. Project operating costs — fixed vs variable cost structure, margin trajectory
5. Calculate UFCF — apply formula above for each projection year
6. Determine WACC — build up each component with sourced inputs
7. Calculate terminal value — both methods, cross-check for reasonableness
8. Discount to present — apply discount factors, sum PV of FCFs and TV
9. Build equity bridge — subtract non-equity claims to arrive at equity value per share
10. Run sensitivity analysis — WACC vs growth rate, WACC vs exit multiple

Sensitivity / Scenario Analysis

Build two-dimensional sensitivity tables:

Table 1: WACC vs Terminal Growth Rate

             | g = 1.5% | g = 2.0% | g = 2.5% | g = 3.0%
WACC = 8.0%  |   $XX    |   $XX    |   $XX    |   $XX
WACC = 8.5%  |   $XX    |   $XX    |   $XX    |   $XX
WACC = 9.0%  |   $XX    |   $XX    |   $XX    |   $XX
WACC = 9.5%  |   $XX    |   $XX    |   $XX    |   $XX

Table 2: WACC vs Exit Multiple

             | 8.0x | 9.0x | 10.0x | 11.0x
WACC = 8.0%  | $XX  | $XX  |  $XX  |  $XX
WACC = 9.0%  | $XX  | $XX  |  $XX  |  $XX

Football Field Chart

Present valuation ranges from multiple methodologies side by side:

• DCF (Gordon Growth) — low to high from sensitivity
• DCF (Exit Multiple) — low to high from sensitivity
• Trading Comps — 25th to 75th percentile
• Precedent Transactions — 25th to 75th percentile
• 52-Week Trading Range
• Analyst Price Targets

Templates

DCF Summary Output

=== DCF VALUATION SUMMARY ===

Company: [Name]
Valuation Date: [Date]
Currency: [CCY]

--- Unlevered Free Cash Flow Projections ($ millions) ---
                    Year 1   Year 2   Year 3   Year 4   Year 5   Terminal
Revenue              ____     ____     ____     ____     ____     ____
EBIT                 ____     ____     ____     ____     ____     ____
UFCF                 ____     ____     ____     ____     ____

--- WACC Build-Up ---
Risk-Free Rate:        ___%
Equity Risk Premium:   ___%
Beta (levered):        ___
Cost of Equity:        ___%
Pre-Tax Cost of Debt:  ___%
Tax Rate:              ___%
Debt / Total Capital:  ___%
WACC:                  ___%

--- Valuation ---
PV of FCFs:            $____m
PV of Terminal Value:  $____m  (___% of EV)
Enterprise Value:      $____m

--- Equity Bridge ---
Less: Net Debt         ($____m)
Less: Minority Int.    ($____m)
Equity Value:          $____m
Diluted Shares:        ____m
Equity Value/Share:    $____

--- Implied Multiples ---
EV / EBITDA (NTM):     ___x
P/E (NTM):             ___x

Quality Gate

Before finalizing a DCF, verify:

• Terminal growth rate does not exceed long-run nominal GDP growth (1.5-3.0%)
• Terminal value is 60-80% of enterprise value — flag if outside this range
• WACC is within reasonable range for the sector and risk profile (6-12% typical)
• Implied multiples from DCF are cross-checked against trading comps
• Revenue growth rates converge to sustainable level by terminal year
• Capex ≈ depreciation in terminal year (steady state assumption)
• Working capital assumptions are consistent with historical days metrics
• Diluted share count uses treasury stock method for options/warrants
• Stock-based compensation is treated consistently (deducted from UFCF)
• Sensitivity tables span a meaningful range and the base case is centered
• All inputs are sourced and documented (Rf, ERP, beta source, tax rate basis)
• Mid-year convention is applied if cash flows are evenly distributed
• Currency of cash flows matches currency of discount rate components