What is a DCF and how does it value a company from fundamentals?

Standard Framework

"A DCF values a company based on the Present Value of its Cash Flows and the Present Value of its Terminal Value."

Step 1: Project Free Cash Flow — Project financials for 5-10 years using assumptions for revenue growth, margins, and working capital. Calculate Unlevered Free Cash Flow for each year.

Step 2: Calculate Terminal Value — Capture cash flows beyond the projection period using either the Multiples Method or Gordon Growth Method.

Step 3: Discount to Present Value — Discount forecast period cash flows and Terminal Value to present using WACC.

Step 4: Enterprise Value to Equity Value — Sum present values to get Enterprise Value. Subtract Net Debt and Minority Interest to arrive at Equity Value. Divide by diluted share count for intrinsic share price.

Free Cash Flow (FCF)

What It Is: The actual cash a company generates that's available to all capital providers—both debt and equity holders—after funding operations and reinvesting in the business. This is Unlevered Free Cash Flow (UFCF), meaning it's calculated before interest payments.

How to Calculate It:

$$\text{UFCF}=\text{[EBIT](/readings/technical/accounting/ebit)}\times (1-\text{Tax Rate})+\text{D\&A}-\text{CapEx}-\Delta \text{NWC}$$

Start with EBIT (operating income), tax-effect it, add back D&A (non-cash), subtract CapEx (cash spent on assets), and subtract increases in Net Working Capital (cash tied up in operations).

Key Consideration: The projection period is where your assumptions live. Revenue growth, margin expansion, CapEx intensity—every assumption compounds over 5-10 years. Small errors become massive swings in valuation. Sensitivity analysis is mandatory.

Weighted Average Cost of Capital (WACC)

What It Is: The blended rate of return required by all capital providers, weighted by their proportion of the capital structure. It represents the opportunity cost of investing in this company versus alternatives of similar risk.

How to Calculate It:

$$\text{WACC}=\frac{E}{E+D}\times r_e+\frac{D}{E+D}\times r_d\times (1-T)$$

• E/(E+D) = Equity weight (use market values, not book)
• r_e = Cost of Equity (typically via CAPM)
• D/(E+D) = Debt weight
• r_d = Cost of Debt (yield on existing debt or comparable bonds)
• (1 - T) = Tax shield on interest

Key Consideration: WACC must match the cash flows being discounted. UFCF is pre-interest, so you use WACC (which reflects both debt and equity). If you used Levered FCF, you'd discount by Cost of Equity alone. Mismatching the discount rate to the cash flow type is a fatal error.

Terminal Value

What It Is: The value of all cash flows beyond your explicit forecast period. Because you can't project FCF forever, Terminal Value captures the remaining value in a single number. It typically represents 60-80% of total DCF value—making it the most consequential (and dangerous) assumption.

How to Calculate It:

Method 1: Perpetuity Growth (Gordon Growth Model)

$$\text{TV}=\frac{{\text{FCF}}_{n+1}}{\text{WACC}-g}=\frac{{\text{FCF}}_n\times (1+g)}{\text{WACC}-g}$$

• g = Perpetual growth rate (typically 2-3%, in line with long-term GDP/inflation)

Method 2: Exit Multiple

$$\text{TV}={\text{[EBITDA](/readings/technical/accounting/ebitda)}}_n\times \text{Exit Multiple}$$

• Exit Multiple derived from current trading comps or precedent transactions

Key Consideration: Perpetual growth rate cannot exceed WACC—mathematically, it produces negative or infinite values. Practically, no company grows faster than the economy forever. If your terminal growth rate is 4% and WACC is 9%, you're implying this company will eventually become the entire economy.

Which Terminal Value Method is Better?

The Bridge from Enterprise Value to Share Price

What It Is: DCF yields Enterprise Value—the value of the operating business to all stakeholders. To get to equity value (what shareholders own), you must adjust for non-operating items and claims that rank ahead of equity.

How to Calculate It:

$$\text{Equity Value}=\text{Enterprise Value}-\text{Net Debt}+\text{Non-Operating Assets}$$ $$\text{Share Price}=\frac{\text{Equity Value}}{\text{Diluted Shares Outstanding}}$$

Key Consideration: Use diluted shares, not basic. Treasury stock method for options and warrants in-the-money. Forgetting dilution overstates price per share.

Follow-Up Traps

"Why add back Depreciation?"

Non-cash expense. CapEx already captures the cash outflow; depreciation is an accounting charge that reduced taxes. Add it back to reflect true cash generation.

"Why use WACC?"

Unlevered Free Cash Flow belongs to both debt and equity holders. WACC represents the blended required return, weighted by capital structure proportions.

Interview Script

DCF is an intrinsic valuation method that values a company by projecting its future cash flows and discounting them back to present value using a rate that reflects the riskiness of those cash flows. The core principle is that a dollar today is worth more than a dollar tomorrow, and a risky dollar is worth less than a safe one. It's worth noting that terminal value typically drives 60-80% of the output, making the model highly sensitive to your growth and WACC assumptions.