Discounted Cash Flow Valuation: A Practitioner's Guide

The Core Logic (Why It Matters)

Every investment you make involves trading dollars today for dollars tomorrow. DCF forces you to make that trade explicit: what are those future dollars worth right now?

The formula looks deceptively simple:

V0 = Sum of [CFt / (1+r)^t]

Where:

• V0 = Present value (what the business is worth today)
• CFt = Cash flow in period t
• r = Discount rate (your required return)

The point is: DCF does not tell you what a stock will trade for next week. It tells you what a business is worth if your assumptions prove correct. Those assumptions carry enormous weight (more on this shortly).

FCFF vs FCFE (Choosing Your Cash Flow)

You have two paths, and mixing them up will destroy your valuation.

Free Cash Flow to Firm (FCFF)

FCFF = EBIT(1-t) + Depreciation - CapEx - Change in Working Capital

This measures cash available to all capital providers—debt holders, equity holders, everyone. You discount FCFF at WACC (the blended cost of all capital) to arrive at enterprise value.

Use FCFF when:

• You are valuing the entire business
• Capital structure is expected to change significantly
• You want to compare companies with different leverage

Free Cash Flow to Equity (FCFE)

FCFE = FCFF - Interest(1-t) + Net Borrowing

This measures cash available only to equity holders after debt payments. You discount FCFE at cost of equity to get equity value directly.

Use FCFE when:

• You are focused exclusively on equity value
• Capital structure is stable
• Debt levels are predictable

The durable lesson: FCFF discounted at WACC yields enterprise value. FCFE discounted at cost of equity yields equity value. Mixing these creates garbage. A Kaplan and Ruback (1995) study in the Journal of Finance showed you can always fit a given market value to a DCF expression—infinite combinations of expected cash flows and discount rates exist. The discipline is in the consistency.

Worked Example: FCFF Calculation

Consider a manufacturing company with these figures:

FCFF = $100M x (1 - 0.25) + $15M - $20M - $5M FCFF = $75M + $15M - $20M - $5M = $65 million

This $65 million is the cash the business generates for everyone who financed it. To convert to equity value, you subtract net debt from the enterprise value you calculate.

Terminal Value (The 70-80% Problem)

Here is what separates textbook DCF from real-world practice: terminal value typically contributes 70-80% of your total valuation. Sometimes more.

Read that again. Most of your valuation comes from assumptions about what happens after your explicit forecast period ends.

Why this matters: When terminal value exceeds 85% of total DCF value, your assumptions need scrutiny. You are essentially saying "I cannot forecast the next five years with confidence, but I am certain about perpetuity."

Method 1: Perpetuity Growth Formula

TV = (Final Year FCF x (1 + g)) / (r - g)

Where g is the perpetual growth rate (typically 2-4% in developed markets).

Critical constraint: g must be less than r. If g >= r, your formula produces infinite or negative values—mathematical nonsense.

Example calculation:

• Final Year FCF: $65 million
• Growth rate (g): 2.5%
• Discount rate (r): 9%

TV = ($65M x 1.025) / (0.09 - 0.025) = $66.625M / 0.065 = $1,025 million

Method 2: Exit Multiple

TV = Final Year EBITDA x Exit Multiple

You derive the exit multiple from current trading multiples of comparable companies. If similar businesses trade at 8x EBITDA today, you might use 7-9x as your exit range.

Example:

• Final Year EBITDA: $120 million
• Exit Multiple: 8x

TV = $120M x 8 = $960 million

The durable lesson: Both methods should produce roughly similar results. If perpetuity growth gives you $1 billion and exit multiples give you $500 million, at least one assumption is wrong.

The Terminal Value Trap (Case Study)

An analyst valued a telecommunications firm using a 5% perpetual growth rate in an economy with 2% GDP growth. The result: terminal value inflated by 40%, making the entire valuation unreliable.

The rule: Perpetual growth cannot exceed long-term GDP growth. No company grows faster than the economy forever—eventually it would become the entire economy. A 2-3% perpetual growth rate covers inflation plus modest real growth. Anything higher demands justification.

Discount Rate Sensitivity (Why Small Changes Matter)

A 1% change in discount rate can alter your valuation by 10-15%.

Consider our $65 million FCFF example with the terminal value we calculated:

This sensitivity compounds when you are discounting terminal value (which is most of your valuation) over five or more years. The effect is multiplicative, not additive.

The point is: Your discount rate assumptions are not neutral choices. They embed real beliefs about risk that dominate your final number.

Common Errors That Destroy DCF Models

Error 1: Including Historical Cash Flows

Impact: 15-20% valuation inflation, potentially impacting deal pricing by tens of millions.

DCF values only future cash flows. Historical performance informs your projections but never enters the discounting calculation.

Error 2: Forgetting to Discount Terminal Value

You calculate terminal value at the end of your forecast period (say, Year 5). That terminal value must be discounted back to today:

Present Value of TV = TV / (1 + r)^5

Adding undiscounted terminal value to discounted annual cash flows is arithmetic that fails basic time value logic.

Error 3: Mismatching Cash Flows and Discount Rates

The chain of logic:

• FCFF (unlevered) -> Discount at WACC -> Enterprise Value
• FCFE (levered) -> Discount at Cost of Equity -> Equity Value

Using WACC for levered cash flows or cost of equity for unlevered creates values that mean nothing.

Error 4: Growth Rate Exceeds Discount Rate

When g > r in the perpetuity formula, you get mathematical impossibility. Your model will produce infinite or negative terminal values. This is a sign your assumptions are internally inconsistent.

When DCF Works Best (And When It Does Not)

DCF excels for:

• Companies with stable, predictable cash flows
• Mature businesses with established patterns
• Firms where you have reasonable confidence in forecasts

DCF struggles with:

• Early-stage companies burning cash
• Highly cyclical businesses
• Companies undergoing significant transformation
• Any situation where 5-year forecasts are pure speculation

Why this matters: Few companies, especially mid-market ones, can accurately project financial results 5 years into the future. DCF precision is illusory when your inputs are guesswork.

Cross-Checking Your Results

Never rely on DCF alone. Your DCF value should make sense relative to:

• Trading multiples of comparable public companies
• Transaction multiples from recent M&A deals
• Reverse DCF (what growth rate does the current price imply?)

If your DCF says $50/share and every comparable company trades at multiples implying $30/share, one of these is wrong. The discipline is figuring out which.

Building Your DCF: Practical Sequence

1. Forecast explicit period cash flows (typically 3-5 years)
2. Calculate terminal value using both perpetuity and exit multiple methods
3. Discount all cash flows to present value at appropriate rate
4. Sum to get enterprise value
5. Subtract net debt to arrive at equity value
6. Divide by shares outstanding for per-share value
7. Sensitivity test discount rate and growth assumptions

The durable lesson: A DCF model is only as good as its assumptions. Document every input, know where each number comes from, and test what happens when you are wrong.

Next Step

Build a DCF model for a mature, cash-flow-positive company you understand (consumer staples and utilities offer stable patterns). Start with three years of explicit forecasts, use conservative terminal assumptions, and stress-test your discount rate by +/- 1%. Compare your result to current trading multiples. The gap between your intrinsic value and market price is your margin of safety—or your margin of error.