Discounted Cash Flow (DCF)

Step 1: Project unlevered free cash flows for 5–10 years using revenue growth, margin, and working capital assumptions. Step 2: Calculate terminal value (the value of all cash flows beyond the projection period) using the perpetuity growth method or exit multiple method. Step 3: Determine WACC by blending the cost of equity and after-tax cost of debt. Step 4: Discount each year's FCF and the terminal value back to present value. Step 5: Sum all present values to get enterprise value, then bridge to equity value per share.

Terminal value typically represents 60–80% of total DCF value, making it the single most impactful assumption. The perpetuity growth method: TV = Final Year FCF × (1 + g) / (WACC - g), where g is the long-term growth rate (usually 2–3%, in line with GDP). The exit multiple method: TV = Terminal Year EBITDA × Exit EV/EBITDA Multiple. Best practice is to calculate both and check they produce similar results. If they diverge significantly, your assumptions need revisiting.

A DCF is most useful for stable, cash-flow-generating businesses with predictable growth. It works best for mature companies in sectors like industrials, consumer staples, and healthcare. It is less reliable for early-stage companies with no cash flows, highly cyclical businesses, and financial institutions (where cash flow is harder to define). For banks and insurance companies, dividend discount models (DDMs) are preferred. For pre-revenue startups, comparable company analysis or venture capital methods are used instead.

Over-optimistic revenue growth is the #1 mistake — always sanity-check against industry growth rates. Using a terminal growth rate above long-term GDP growth implies the company will eventually be larger than the economy. Not sensitivity-testing WACC and terminal assumptions creates a false sense of precision. Forgetting to mid-year discount (if cash flows arrive throughout the year, not just at year-end). Failing to adjust for stock-based comp, operating leases, or pension obligations in the EV bridge.