intrinsic-valuation-dcf
Intrinsic Valuation (DCF)
Table of Contents
Example
Scenario: Two-stage FCFF model for a mature growth company
Inputs:
- Base year EBIT: $500M, Tax rate: 25%, CapEx: $200M, Depreciation: $150M, WC change: $20M
- High-growth period: 5 years, revenue growth 12%, reinvestment rate 50%, WACC 9%
- Stable period: perpetual growth 3%, reinvestment rate 30%, WACC 8.5%
Step-by-step:
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Base year after-tax operating income: $500M x (1 - 0.25) = $375M
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Base year FCFF: $375M - ($200M - $150M) - $20M = $305M
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Year-by-year projections (high-growth, 12% growth, 50% reinvestment):
| Year | After-tax EBIT | Reinvestment | FCFF | PV Factor (9%) | PV of FCFF |
|---|---|---|---|---|---|
| 1 | $420.0M | $210.0M | $210.0M | 0.9174 | $192.7M |
| 2 | $470.4M | $235.2M | $235.2M | 0.8417 | $198.0M |
| 3 | $526.8M | $263.4M | $263.4M | 0.7722 | $203.4M |
| 4 | $590.1M | $295.0M | $295.0M | 0.7084 | $208.9M |
| 5 | $660.9M | $330.4M | $330.4M | 0.6499 | $214.8M |
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Terminal value (end of year 5):
- Stable FCFF = $660.9M x (1.03) x (1 - 0.30) = $476.5M
- Terminal value = $476.5M / (0.085 - 0.03) = $8,663M
- PV of terminal value = $8,663M x 0.6499 = $5,631M
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Firm value = $1,017.8M + $5,631M = $6,649M
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Equity bridge:
- Firm value: $6,649M
- Minus debt: -$2,000M
- Plus cash: +$500M
- Minus employee options: -$200M
- Equity value: $4,949M
- Per share (100M shares): $49.49
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Sensitivity grid (per-share value):
| WACC \ Growth | 2.0% | 2.5% | 3.0% | 3.5% | 4.0% |
|---|---|---|---|---|---|
| 7.5% | $62 | $68 | $76 | $86 | $99 |
| 8.0% | $53 | $57 | $62 | $69 | $78 |
| 8.5% | $45 | $48 | $52 | $57 | $63 |
| 9.0% | $39 | $41 | $44 | $48 | $52 |
| 9.5% | $34 | $36 | $38 | $41 | $44 |
Workflow
Copy this checklist and track your progress:
DCF Valuation Progress:
- [ ] Step 1: Select DCF model variant
- [ ] Step 2: Establish base year cash flows
- [ ] Step 3: Estimate growth rate and high-growth period length
- [ ] Step 4: Project year-by-year cash flows
- [ ] Step 5: Compute terminal value
- [ ] Step 6: Discount, bridge to equity, compute per-share value
- [ ] Step 7: Build sensitivity analysis
Step 1: Select DCF model variant
Choose the model that matches the company and context. See resources/methodology.md for the full decision tree.
Quick selection guide:
- FCFF: Default for most companies. Values the entire firm, discounts at WACC, subtracts debt for equity. Use when capital structure is expected to change or when the company has significant debt.
- FCFE: Values equity directly, discounts at cost of equity. Use when capital structure is stable and debt ratio is predictable.
- DDM: Values equity via dividends, discounts at cost of equity. Use for mature, stable dividend-paying companies (utilities, REITs, mature banks).
Step 2: Establish base year cash flows
Start from cleaned financials (ideally from financial-statement-analyzer output). See resources/template.md for the base year input template.
For FCFF:
- After-tax operating income = EBIT x (1 - tax rate)
- FCFF = After-tax EBIT - (CapEx - Depreciation) - Change in non-cash working capital
For FCFE:
- FCFE = Net Income - (CapEx - Depreciation) - Change in WC + (New debt issued - Debt repaid)
For DDM:
- Current dividends per share, payout ratio, earnings per share
Step 3: Estimate growth rate and high-growth period length
See resources/methodology.md for growth estimation methods.
Three approaches to estimating growth:
- Fundamental: g = Reinvestment rate x Return on capital (for FCFF) or g = Retention ratio x ROE (for FCFE/DDM)
- Historical: Extrapolate recent growth with judgment about sustainability
- Analyst consensus: Use as cross-check, not primary source
High-growth period length depends on competitive advantage magnitude and sustainability (typically 5-10 years).
Step 4: Project year-by-year cash flows
Build the projection table for each year of the high-growth period. See resources/template.md for the projection template.
For each year, compute:
- Revenue (or operating income) based on growth rate
- Reinvestment (based on reinvestment rate or sales-to-capital ratio)
- Free cash flow = Income after tax - Reinvestment
- Present value factor = 1 / (1 + discount rate)^year
- Present value of cash flow
Step 5: Compute terminal value
See resources/methodology.md for terminal value approaches and constraints.
Growing perpetuity (preferred):
- Terminal value = CF in year n+1 / (discount rate - stable growth rate)
- Stable growth rate should not exceed the risk-free rate or nominal GDP growth
- Reinvestment rate in stable period: g / ROC (so growth is consistent with reinvestment)
- Cost of capital should converge toward mature company levels
Exit multiple cross-check (secondary):
- Apply industry EV/EBITDA or PE multiple to terminal year financials
- Compare to perpetuity-based terminal value for reasonableness
Step 6: Discount, bridge to equity, compute per-share value
See resources/template.md for the equity bridge template.
- Sum PV of high-growth cash flows + PV of terminal value = Operating asset value
- Add: Value of cash and non-operating assets
- Subtract: Market value of debt (all debt included in WACC calculation)
- Subtract: Value of employee stock options (use treasury stock method or Black-Scholes)
- Subtract: Minority interests (at market value if available)
- Divide by diluted share count = Per-share intrinsic value
Step 7: Build sensitivity analysis
See resources/template.md for the sensitivity grid template.
At minimum, vary:
- Stable growth rate (rows)
- Discount rate / WACC (columns)
Additional sensitivity dimensions to consider:
- Revenue growth rate in high-growth period
- Target operating margin
- Length of high-growth period
- Reinvestment rate
Validate using resources/evaluators/rubric_intrinsic_valuation_dcf.json. Minimum standard: Average score of 3.5 or higher.
Common Patterns
Pattern 1: FCFF Two-Stage (Most Common)
- When: Company with identifiable high-growth period followed by stable growth. Changing or uncertain capital structure. Most non-financial companies.
- Structure: Project FCFF for 5-10 years at above-normal growth, then terminal value at stable growth. Discount at WACC.
- Equity bridge: Firm value - Debt + Cash - Options = Equity value
- Key risk: Terminal value dominance. If terminal value exceeds 85% of total value, consider whether the high-growth period is too short or growth too low.
Pattern 2: FCFE Two-Stage
- When: Stable, predictable capital structure. Company manages to a target debt ratio. Financial services firms where FCFF is not meaningful.
- Structure: Project FCFE for high-growth period, then terminal value. Discount at cost of equity.
- Equity bridge: Not needed -- result is equity value directly. Subtract option value, divide by shares.
- Key risk: Debt ratio assumption. If actual debt policy deviates from assumption, value will be wrong.
Pattern 3: Dividend Discount Model (DDM)
- When: Mature, stable companies with long dividend track records. Utilities, REITs, mature banks, consumer staples.
- Structure: Project dividends per share, discount at cost of equity. Terminal value uses stable dividend growth.
- Equity bridge: Not needed -- result is per-share equity value.
- Key risk: Dividends may not reflect capacity to pay. If payout ratio is very low, DDM underestimates value. Consider augmented DDM (dividends + buybacks).
Pattern 4: Three-Stage Model
- When: Companies with long growth runways needing a transition period (young growth transitioning through mature growth to stable).
- Structure: Stage 1 (high growth, 5 years), Stage 2 (transition, growth declining linearly, 5 years), Stage 3 (stable perpetuity).
- Key risk: More parameters to estimate. Transition assumptions (how fast growth declines, when margins stabilize) add uncertainty.
Guardrails
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Discounting consistency: Match cash flows to discount rates. FCFF at WACC, FCFE at cost of equity, dividends at cost of equity. Mixing them produces meaningless numbers.
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Stable growth rate ceiling: The stable growth rate should not exceed the risk-free rate (for real cash flows) or nominal GDP growth (for nominal cash flows). A company cannot grow faster than the economy in perpetuity.
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Terminal value proportion: Terminal value typically represents 50-80% of total value for growth firms. Flag if it exceeds 90% -- this may indicate that the high-growth assumptions are too conservative or the growth period too short.
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Reinvestment-growth consistency: In the stable period, reinvestment rate should equal g / ROC. If stable growth is 3% and ROC is 10%, reinvestment rate should be 30%. Disconnect between growth and reinvestment implies value creation from thin air.
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Equity bridge completeness: When using FCFF, bridge from firm value to equity by subtracting the market value of debt that was included in the cost of capital, adding cash and non-operating assets, and subtracting employee option value and minority interests.
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Diluted share count: Use the diluted share count (treasury stock method for in-the-money options) rather than basic shares outstanding. For companies with large option grants, the difference is material.
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Cost of capital convergence: In the stable period, beta should converge toward 1.0, debt ratio toward industry average, and WACC toward the weighted average of the market. A company cannot maintain an extremely high or low cost of capital in perpetuity.
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Sensitivity analysis breadth: Vary at least the growth rate and discount rate. The interaction between these two drivers accounts for most of the valuation range. Report the value as a range, not a point estimate.
Common pitfalls:
- Projecting high growth for too long (10+ years is rare outside pharmaceutical or platform businesses)
- Using book value of debt instead of market value in the equity bridge
- Forgetting to subtract employee stock option value (material for tech companies)
- Double-counting growth: applying a high growth rate to income that already reflects growth spending
- Assuming current margins are sustainable without checking industry convergence
- Using the same WACC for both the high-growth and stable periods when capital structure is expected to change
Quick Reference
Key formulas:
FCFF = After-tax EBIT - (CapEx - Depreciation) - Change in Non-cash WC
= After-tax EBIT x (1 - Reinvestment Rate)
FCFE = Net Income - (CapEx - Depreciation) - Change in WC + Net Debt Issued
= Net Income x (1 - Equity Reinvestment Rate)
DDM = Dividends per Share (growing at g, discounted at ke)
Terminal Value (perpetuity) = CF(n+1) / (r - g_stable)
Growth (fundamental):
g_operating_income = Reinvestment Rate x Return on Capital
g_net_income = Retention Ratio x Return on Equity
Reinvestment Rate = (CapEx - Depreciation + Change in WC) / After-tax EBIT
Equity Bridge:
Equity Value = Firm Value - Debt + Cash - Options - Minority Interests
Per Share = Equity Value / Diluted Shares
Model selection quick guide:
| Situation | Model | Discount Rate | Result |
|---|---|---|---|
| Most companies, changing capital structure | FCFF | WACC | Firm value (bridge to equity) |
| Stable capital structure, predictable debt | FCFE | Cost of equity | Equity value |
| Mature dividend payers | DDM | Cost of equity | Equity value per share |
| Financial services | FCFE or DDM | Cost of equity | Equity value |
| Long growth runway, transition needed | Three-stage | WACC or ke | Depends on variant |
Key resources:
- resources/template.md: Base year inputs, year-by-year projection table, terminal value template, equity bridge, sensitivity grid, value decomposition
- resources/methodology.md: Model selection decision tree, growth estimation methods, terminal value approaches, option adjustment, three-stage mechanics, mid-year convention
- resources/evaluators/rubric_intrinsic_valuation_dcf.json: Quality criteria for model selection, projections, terminal value, equity bridge, sensitivity analysis
Inputs required:
- Current after-tax operating income (FCFF) or net income (FCFE/DDM)
- Current CapEx, depreciation, and working capital change
- Revenue growth rate for high-growth period
- Target operating margin and reinvestment rate (or sales-to-capital ratio)
- Length of high-growth period (years)
- Stable growth rate
- WACC and/or cost of equity (from cost-of-capital-estimator)
- Current debt, cash, minority interests
- Shares outstanding and employee options (number, strike, maturity)
Outputs produced:
dcf-valuation.md: Complete DCF model with year-by-year projections, terminal value, equity bridge, per-share value, sensitivity grid, value decomposition