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DCF for beginners

A discounted cash flow model reduces a company's future to a single number: intrinsic value. The premise is elegant and theoretically sound. Project the free cash the business will generate over the next five to ten years (before any payments to shareholders). Discount those future cash flows back to present value using a discount rate that reflects the risk of those cash flows and the cost of capital. Sum them up, including terminal value at the end of your explicit forecast. That sum is what the business is theoretically worth today, assuming your assumptions are correct.

The power of DCF is that it forces you to be explicit about your assumptions rather than hiding them in hand-waving. How will revenue grow—by what percentage each year, and for how long? How will margins evolve as the company scales, or contract as competition arrives? How much capital will the company need to reinvest in fixed assets and working capital to achieve that revenue growth? What happens in the terminal period after your forecast, when the business reaches maturity and growth slows? Each assumption is a hypothesis about the future that you must defend with logic, historical evidence, and industry precedent. The weakness of DCF is that it is entirely dependent on these assumptions. Change your growth rate by 2 percent, and intrinsic value swings 30 to 40 percent. Change your terminal growth rate from 2 to 3 percent, and value potentially doubles or halves. This forces an uncomfortable truth: DCF does not predict the future. It tests whether your assumptions are internally consistent and plausible, and it reveals how sensitive your valuation is to each key variable.

This chapter teaches DCF mechanics from the ground up, without intimidation or unnecessary complexity. You will learn how to project free cash flows (revenue minus operating expenses minus taxes minus required capital expenditures minus changes in working capital), calculate terminal value correctly (the biggest source of DCF errors), choose an appropriate discount rate, and sensitivity-test your model so you understand how value changes with key assumptions. More importantly, you will learn when DCF adds decision-making value and when it becomes financial theater—impressive-looking but ultimately misleading.

Terminal value: where most errors hide​

Most of a company's DCF value comes from terminal value (the value beyond your explicit forecast period). Get terminal value wrong, and your entire valuation is wrong. But terminal value is also the most subjective assumption you will make. This chapter teaches you to estimate terminal value conservatively and to understand how sensitive your valuation is to changes in that assumption. The goal is humility: recognizing that your terminal value estimate is a best guess, not a forecast.

Discount rate and cost of capital​

The discount rate reflects two things: the time value of money (what returns could you earn elsewhere) and the risk of these specific cash flows. Choose a discount rate too low, and you overvalue the stock. Choose it too high, and you undervalue it. This chapter teaches you how to estimate an appropriate discount rate using the capital asset pricing model and how to adjust for company-specific risks. You will also learn when discount rate changes matter most and when they are second-order.

Articles in this chapter​