Valuation: Discounted Cash Flow

Overview of Discounted Cash Flow Valuation

The Discounted Cash Flow (DCF) model is the cornerstone of intrinsic valuation. It is based on the fundamental principle that the value of any asset is the present value of its expected future cash flows, discounted at a rate that reflects the riskiness of those cash flows. Unlike relative valuation methods (such as comparable company analysis), DCF does not depend on how the market is currently valuing similar companies. Instead, it derives value from first principles, making it the most theoretically sound valuation approach available to research analysts.

The DCF framework involves four key steps: (1) projecting the company's future free cash flows over an explicit forecast period (typically 5-10 years), (2) estimating a terminal value to capture the value of cash flows beyond the explicit forecast period, (3) calculating the appropriate discount rate (Weighted Average Cost of Capital or WACC), and (4) discounting all future cash flows back to the present to determine the company's enterprise value. From enterprise value, the analyst then derives equity value and an implied share price.

Intrinsic Value: The present value of all expected future cash flows generated by a business, discounted at a rate reflecting the risk of those cash flows. Intrinsic value is independent of the current market price. If intrinsic value exceeds the market price, the stock is considered undervalued; if it is below the market price, the stock is considered overvalued.

Free Cash Flow Projection

The cash flows used in a DCF model are Free Cash Flow to the Firm (FCFF), also called Unlevered Free Cash Flow. FCFF represents the cash available to all capital providers (both debt and equity holders) after the company has reinvested in its operations. The formula is:

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

Alternatively: FCFF = NOPAT + D&A - Capex - Change in NWC

Each component requires careful analysis and forecasting:

EBIT (Earnings Before Interest and Taxes): Start with revenue projections and build down through the income statement, forecasting each major line item based on historical trends, management guidance, industry analysis, and the analyst's own judgment
Tax Rate: Use the company's effective tax rate, adjusted for any expected changes. The statutory rate may differ from the effective rate due to tax credits, international operations, and other adjustments
Depreciation & Amortization: D&A is a non-cash charge that is added back because it reduced EBIT but did not represent an actual cash outflow. D&A should be forecast based on the existing asset base and expected capital expenditures
Capital Expenditures: Capex represents the cash invested in fixed assets. Analysts typically forecast capex as a percentage of revenue, considering maintenance requirements and growth plans. Capex guidance from management is an important input
Change in Net Working Capital: Increases in working capital (e.g., growing receivables and inventory) consume cash, while decreases release cash. Working capital is often forecast as a percentage of revenue based on historical patterns

The Series 86 exam tests your understanding of why FCFF uses unlevered cash flow (before interest payments). The reason is that FCFF represents cash available to ALL capital providers. Interest payments are already captured in the WACC discount rate through the cost of debt component. Including interest in both the cash flows and the discount rate would be double-counting. If you use levered cash flows (Free Cash Flow to Equity), you discount by the cost of equity only.

Weighted Average Cost of Capital (WACC)

The WACC is the discount rate used to convert future free cash flows into present value. It represents the blended cost of all capital sources (debt and equity) weighted by their proportions in the company's capital structure. The formula is:

WACC = (E/V) x Re + (D/V) x Rd x (1 - T)

Where:

E = Market value of equity
D = Market value of debt
V = E + D (total capital)
Re = Cost of equity
Rd = Cost of debt (pre-tax)
T = Marginal tax rate

The cost of debt is multiplied by (1 - T) because interest expense is tax-deductible, creating a "tax shield" that effectively reduces the cost of debt financing.

Cost of Equity: The Capital Asset Pricing Model (CAPM)

The most common method for estimating the cost of equity is the Capital Asset Pricing Model:

Re = Rf + Beta x (Rm - Rf)

Where:

Rf = Risk-free rate (typically the yield on a 10-year U.S. Treasury bond)
Beta = A measure of the stock's systematic risk relative to the overall market. A beta of 1.0 means the stock moves in line with the market; above 1.0 means more volatile; below 1.0 means less volatile
Rm - Rf = Equity risk premium (the expected excess return of the market over the risk-free rate, typically estimated at 5-7%)

WACC Calculation: A company has a market cap of $800 million and $200 million in debt, for total capital of $1 billion. Its beta is 1.2, the risk-free rate is 4%, the equity risk premium is 6%, and the pre-tax cost of debt is 5%. The tax rate is 25%.

Cost of equity: Re = 4% + 1.2 x 6% = 4% + 7.2% = 11.2%

After-tax cost of debt: 5% x (1 - 0.25) = 3.75%

WACC = (800/1000) x 11.2% + (200/1000) x 3.75% = 8.96% + 0.75% = 9.71%

Cost of Debt

The cost of debt is the effective interest rate the company pays on its outstanding debt. For publicly traded debt, this can be estimated from the yield to maturity (YTM) on the company's bonds. For private debt, the interest rate on outstanding loans or credit facilities can be used. The cost of debt should reflect the company's current borrowing cost, not the historical coupon rate on old debt issues.

Terminal Value

Because it is impractical to forecast cash flows indefinitely, analysts project explicit cash flows for a limited period (typically 5-10 years) and then estimate a terminal value that captures the value of all cash flows beyond the forecast period. Terminal value typically represents 60-80% of total enterprise value in a DCF, making it one of the most important (and most debated) elements of the analysis.

Gordon Growth Model (Perpetuity Growth Method)

The most common approach assumes that free cash flow grows at a constant rate in perpetuity after the final explicit forecast year:

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

Where FCF(n+1) is the free cash flow in the first year after the explicit forecast period, WACC is the discount rate, and g is the perpetual growth rate. The growth rate should reflect long-term sustainable growth and is typically set between 2-3% (roughly equal to long-term nominal GDP growth). Using a growth rate above 4-5% is generally considered aggressive and will produce unreasonably high terminal values.

Exit Multiple Method

An alternative approach applies a valuation multiple (typically EV/EBITDA) to the final year's financial metric:

Terminal Value = EBITDA(n) x Exit Multiple

The exit multiple is typically based on the current trading multiples of comparable companies or historical averages. While more intuitive than the perpetuity growth model, this method introduces relative valuation assumptions into what is supposed to be an intrinsic valuation framework.

Terminal value is the most sensitive input in a DCF model. Small changes in the perpetual growth rate or exit multiple can dramatically change the implied valuation. The perpetual growth rate must be less than WACC (otherwise the formula produces infinite or negative values). Best practice is to cross-check terminal value using both methods and ensure the implied terminal growth rate (from the exit multiple method) and the implied exit multiple (from the perpetuity growth method) are reasonable.

From Enterprise Value to Equity Value

The DCF model produces Enterprise Value (EV), which represents the total value of the business to all capital providers. To derive the Equity Value (the value that belongs to common shareholders), analysts apply the "bridge" from EV to equity:

Equity Value = Enterprise Value - Net Debt - Preferred Stock - Minority Interest + Associates/JV Investments

Where Net Debt = Total Debt - Cash and Cash Equivalents. The implied share price is then calculated by dividing equity value by the fully diluted share count (using the treasury stock method for options and warrants).

DCF Component	Key Inputs	Common Pitfalls
Free Cash Flow Projection	Revenue growth, margins, capex, working capital	Overly optimistic growth, ignoring cyclicality
WACC	Risk-free rate, beta, ERP, cost of debt, capital weights	Using book values instead of market values for weights
Terminal Value	Perpetual growth rate or exit multiple	Growth rate too high, terminal value dominates
EV-to-Equity Bridge	Net debt, minority interest, diluted shares	Forgetting to deduct debt or adjust for dilution

Sensitivity Analysis

Because DCF models rely on numerous assumptions, responsible analysts always present their results with sensitivity analysis that shows how the implied value changes under different assumptions. The two most common forms are:

Two-variable sensitivity tables: Show the implied share price across a range of two key assumptions (e.g., WACC and terminal growth rate, or revenue growth and operating margin). These tables communicate the range of possible outcomes and highlight which assumptions have the greatest impact on valuation.

Scenario analysis: Defines specific cases (base case, upside case, downside case) with different sets of assumptions for revenue growth, margins, and capital requirements. Each scenario produces a different implied value, and the analyst assigns probabilities to each scenario to compute an expected value.

Sensitivity analysis is not merely an academic exercise; it is essential for communicating the uncertainty inherent in any valuation. An analyst who presents a single point estimate without sensitivity analysis is implying a false precision that does not exist. Well-constructed sensitivity analysis builds credibility with investors and helps them understand the key drivers of value and the risks to the investment thesis.

A DCF model is only as good as its assumptions. The terminal value typically represents 60-80% of total value, making the perpetual growth rate and WACC the most impactful inputs. Always cross-check your DCF output against comparable company multiples and precedent transactions. If your DCF implies a valuation dramatically different from market pricing, carefully re-examine your assumptions before concluding the market is wrong.