calculate-dcf

Calculate DCF

Build a discounted cash flow valuation to estimate the intrinsic value of an asset.

Why This Is Best Practice

Adopted by: CFA Institute, investment banks (Goldman Sachs, Morgan Stanley), private equity firms globally Impact: DCF remains the dominant valuation methodology for intrinsic value; Damodaran's NYU research shows it outperforms multiples-based methods for long-horizon investments.

Why best: DCF forces explicit assumptions about growth, margins, and risk, making them auditable. Unlike comparable-company analysis, DCF anchors value to fundamental cash generation rather than market sentiment. Proper WACC construction links capital structure to the discount rate, keeping the model internally consistent.

Steps

1. Project free cash flow — Forecast FCFF (EBIT × (1 − tax rate) + D&A − CapEx − ΔNWC) for 5–10 years; use three scenarios (base, bull, bear).
2. Determine the discount rate (WACC) — WACC = (E/V) × Re + (D/V) × Rd × (1 − T); use CAPM for cost of equity (Re = Rf + β × ERP); source beta from comparable public firms if private.
3. Estimate terminal value — Apply Gordon Growth Model (TV = FCFFn+1 / (WACC − g)) or exit-multiple method; g should not exceed long-run nominal GDP growth (~3–4%).
4. Discount all cash flows — PV = Σ [FCFFt / (1 + WACC)^t] + TV / (1 + WACC)^n.
5. Calculate equity value — Enterprise Value = PV of FCFFs + TV; Equity Value = EV − Net Debt − Minority Interest + Cash.
6. Run sensitivity analysis — Build a two-way table varying WACC (±100 bps) and terminal growth rate (±50 bps); this is mandatory, not optional.
7. Sanity-check against comps — Validate implied EV/EBITDA and P/E multiples against industry peers; large deviations demand explanation.
8. State assumptions explicitly — Document every key assumption with its rationale; a DCF is only as trustworthy as its inputs.

Rules

• Never use a terminal growth rate above the long-run nominal GDP growth rate.
• Always discount terminal value at the same WACC as interim cash flows.
• Use unlevered free cash flow (FCFF) when computing enterprise value; switch to FCFE only for equity value directly.
• Perform sensitivity analysis on at minimum WACC and terminal growth rate before presenting results.
• Cross-check equity value per share against current market price; document the implied premium or discount.

Examples

SaaS company, 5-year horizon: Revenue $50M growing 30% YoY, EBIT margin expanding from 10% to 25%, WACC = 12%, terminal growth = 3%. Base-case equity value = $420M vs. market cap of $380M → 10.5% upside; bear case = $290M, bull case = $610M. Sensitivity table shows value crosses market price at WACC > 13.8%.

Common Mistakes

• Using book-value weights for WACC — WACC must use market-value weights; book values systematically understate equity.
• Ignoring working-capital changes — Failing to include ΔNWC overstates FCF for high-growth businesses.
• Single-point estimate without sensitivity — A DCF without sensitivity analysis is false precision; ranges are the real output.
• Terminal value dominating EV (>80%) — Signals projection period is too short or growth assumptions are too aggressive.

Finance disclaimer: This skill encodes professional best practices for educational purposes. It is not financial advice. Consult a licensed financial advisor before making investment decisions.