Discounted Cash Flow Steps

Why This Matters

Discounted Cash Flow (DCF) analysis is the backbone of intrinsic valuation—it's how you determine what a company is actually worth based on its ability to generate cash, not just what the market says it's worth today. You're being tested on your ability to connect forecasting assumptions, risk assessment, and time value of money into a coherent valuation framework. Every investment banking interview, every M&A deal, and every corporate finance exam will expect you to walk through this process fluently.

Don't just memorize the steps in order—understand why each step exists and what happens to your valuation if you get it wrong. A flawed discount rate assumption can swing your valuation by billions. A terminal value built on unrealistic growth destroys your credibility. Know the mechanics, but more importantly, know the judgment calls that separate a rigorous DCF from a garbage-in-garbage-out exercise.

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Building the Foundation: Cash Flow Projections

The entire DCF rests on your ability to forecast what a business will actually generate. This is where financial modeling meets business judgment—you're translating strategic assumptions into numbers.

Forecast Future Cash Flows

• Project unlevered free cash flows—these are cash flows before interest payments, isolating operating performance from capital structure decisions
• Use 5-10 year forecast horizons to capture full business cycles; shorter periods miss cyclicality, longer periods compound forecasting errors
• Build scenario analyses (best case, base case, worst case) to stress-test your assumptions and understand valuation sensitivity

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Quantifying Risk: The Discount Rate

The discount rate is your mechanism for adjusting future cash flows for risk and the time value of money. Getting this wrong is the fastest way to produce a meaningless valuation.

Determine the Appropriate Discount Rate

• WACC (Weighted Average Cost of Capital) is the standard discount rate for enterprise valuation—it blends the cost of debt and equity weighted by capital structure
• Match risk to rate—higher uncertainty in cash flows demands a higher discount rate; a stable utility and a speculative biotech shouldn't share the same WACC
• Reflect opportunity cost—the rate must represent what investors could earn on comparable-risk investments, not an arbitrary hurdle

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Time Value Mechanics: Present Value Calculations

This is where the math happens. You're converting future dollars into today's dollars using the discount rate you've established. Every dollar received later is worth less than a dollar today.

Calculate the Present Value of Forecasted Cash Flows

• Apply the core formula: $PV = \frac{FCF_n}{(1 + r)^n}$ where $r$ is the discount rate and $n$ is the year
• Discount each year's cash flow individually—then sum them to get total present value of the explicit forecast period
• Compounding errors multiply—a small mistake in Year 1 cascades through every subsequent calculation, so check your work

Estimate the Terminal Value

• Terminal value captures everything beyond your forecast—often 60-80% of total DCF value, making this the most sensitive assumption in your model
• Choose your method: the Gordon Growth Model ($TV = \frac{FCF_{n+1}}{r - g}$) assumes perpetual growth, while the Exit Multiple Method applies a market multiple to terminal year metrics
• Keep growth rates realistic—terminal growth ($g$) should never exceed long-term GDP growth; using 5% when the economy grows at 2-3% signals a flawed model

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From Enterprise Value to Equity Value

Once you've calculated what the business operations are worth, you need to bridge to what shareholders actually own. This is where capital structure enters the picture.

Sum Present Values to Arrive at Enterprise Value

• Enterprise Value = PV of forecast cash flows + PV of terminal value—this represents the total value of the firm's operating assets
• EV is capital-structure neutral—it values the business regardless of how it's financed, making it ideal for comparing companies with different debt levels
• Double-check your terminal value discount—remember to bring terminal value back to Year 0, not leave it in the final forecast year

Adjust for Non-Operating Assets and Liabilities

• Add non-operating assets like excess cash, marketable securities, or equity investments that aren't captured in your operating cash flow forecasts
• Subtract non-operating liabilities—pension shortfalls, contingent liabilities, or environmental obligations that represent real claims on value
• This step isolates core operations—you're ensuring your valuation reflects the business you're actually analyzing, not peripheral items

Subtract Net Debt to Calculate Equity Value

• Net Debt = Total Debt − Cash and Cash Equivalents—this represents the net claim that debt holders have on enterprise value
• Equity Value = Enterprise Value − Net Debt—what remains after satisfying debt claims belongs to shareholders
• Watch for debt-like items—capital leases, preferred stock, and minority interests often need to be treated as debt for this calculation

Divide Equity Value by Shares Outstanding for Per-Share Value

• Intrinsic value per share = Equity Value ÷ Diluted Shares Outstanding—use diluted shares to account for options, warrants, and convertibles
• Compare to market price—if intrinsic value exceeds market price, the stock may be undervalued; if below, potentially overvalued
• This is your investment signal—the entire DCF process culminates in this single number that drives buy/sell/hold decisions

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Quick Reference Table

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Self-Check Questions

1. Why must you use unlevered free cash flows when building a DCF that uses WACC as the discount rate?

2. Compare and contrast the Gordon Growth Model and Exit Multiple Method for terminal value—when would you prefer one over the other?

3. If two companies have identical enterprise values but different equity values, what's the most likely explanation?

4. A company has $EV = \$500M$, excess cash of $\$50M$, and net debt of $\$150M$. Walk through how you'd calculate equity value, identifying where the excess cash adjustment occurs.

5. Your DCF produces an intrinsic value of $\$45$ per share, but the stock trades at $\$60$. What are three possible explanations—and which DCF inputs would you revisit first?