DCF Stock Valuation
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1. 1. What DCF Valuation Measures
2. 2. Starting With Free Cash Flow
3. 3. Projecting Revenue and Margins
4. 4. Building the Example Cash Flows
5. 5. Choosing the Discount Rate
6. 6. Estimating Terminal Value
7. 7. Discounting Cash Flows to Today
8. 8. From Enterprise Value to Share Value
9. 9. Comparing Value With Market Price
10. 10. Testing Assumptions and Limits
1. 1. What DCF Valuation Measures
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Why does DCF focus on cash flow rather than accounting profit?
Cash flow is closer to the money available to investors, while accounting profit can include non-cash items and timing effects.
Can a DCF prove the exact value of a stock?
No. It provides an estimate based on assumptions, so the result should be treated as a valuation range rather than a precise truth.
DCF valuation: A method that values an asset by discounting expected future cash flows to present value.
Present value: The value today of a future amount after adjusting for time and risk.
Intrinsic value: An estimate of what a stock is worth based on fundamentals rather than market sentiment.
Market price: The current price at which investors can buy or sell the stock.
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2. 2. Starting With Free Cash Flow
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Is free cash flow the same as net income?
No. Net income is an accounting measure, while free cash flow adjusts for non-cash expenses, investment spending, and working capital needs.
What if the company has negative free cash flow today?
A DCF can still be built, but the forecast must clearly explain when and why free cash flow should turn positive.
FCFF: Free cash flow available to all capital providers before interest payments.
EBIT: Operating profit before deducting interest expense and taxes.
CapEx: Cash spent on property, equipment, technology, or other long-term productive assets.
Net working capital: Operating current assets minus operating current liabilities, excluding financing items.
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3. 3. Projecting Revenue and Margins
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How many years should be forecast in a basic DCF?
Five years is common for a simple model, though longer periods may be needed for young or cyclical businesses.
Should revenue growth stay high forever?
Usually not. Growth should slow over time as companies become larger and markets mature.
Revenue growth: The expected percentage increase in sales over a period.
Operating margin: EBIT divided by revenue, showing operating profitability before financing costs.
Forecast period: The explicit number of years for which cash flows are projected individually.
Competitive position: The strength of a company’s market advantages, such as brand, scale, or switching costs.
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4. 4. Building the Example Cash Flows
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Why is depreciation added back but CapEx subtracted?
Depreciation is a non-cash accounting charge, while CapEx is an actual cash investment in long-term assets.
Why does growing revenue often require more working capital?
Higher sales may require more inventory and receivables, which can temporarily consume cash.
After-tax operating profit: Operating profit after taxes, often called NOPAT, before financing costs.
D&A add-back: Depreciation and amortization are added back because they reduce accounting profit but not cash directly.
Working capital increase: Additional cash tied up in receivables, inventory, or other operating needs.
Forecast FCF: The estimated annual free cash flow used as the main input in a DCF model.
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5. 5. Choosing the Discount Rate
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Why use WACC instead of the cost of equity?
WACC is used with FCFF because those cash flows are available to all capital providers, not just shareholders.
What happens if the discount rate is too low?
The valuation can become too high because risky future cash flows are treated as if they are safer than they really are.
Discount rate: The required return used to translate future cash flows into present value.
WACC: The blended cost of equity and debt financing, adjusted for the tax benefit of debt.
Cost of equity: The return shareholders require for bearing the risk of owning the stock.
Cost of debt: The borrowing return required by lenders, usually based on interest rates and credit risk.
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6. 6. Estimating Terminal Value
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Why is terminal value often so important in a DCF?
Because businesses may operate for many years after the explicit forecast period, so later cash flows can represent much of the value.
Can the perpetual growth rate be higher than the discount rate?
No. If growth equals or exceeds the discount rate, the formula breaks down and implies unrealistic infinite value.
Terminal value: The estimated value of all cash flows after the explicit forecast period.
Perpetual growth: A stable long-term growth rate assumed to continue indefinitely.
Final forecast-year FCF: The last annual cash flow in the explicit projection period.
Continuing value: Another name for terminal value, emphasizing cash flows beyond the forecast window.
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7. 7. Discounting Cash Flows to Today
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Why is the terminal value discounted by five years?
It is estimated at the end of the fifth forecast year, so it must be brought back five periods to today.
Why do later cash flows usually have lower present values?
They are received further in the future and are divided by a larger discount factor.
Present value factor: The divisor \( (1+r)^t \) used to discount a future amount.
Discounted FCF: A forecast free cash flow converted into today’s dollars.
Enterprise value: The value of the operating business available to both debt and equity investors.
Time value of money: The principle that money available today is worth more than the same amount in the future.
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8. 8. From Enterprise Value to Share Value
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Why subtract debt from enterprise value?
Debt holders have a claim on the business value before common shareholders, so debt reduces the value available to equity.
Why add cash by using net debt?
Excess cash belongs to the company’s owners and offsets debt obligations, increasing equity value.
Equity value: The value attributable to common shareholders after accounting for debt and cash.
Net debt: Total debt minus cash and cash equivalents.
Shares outstanding: The number of common shares currently issued and held by investors.
Intrinsic value per share: Estimated equity value divided by shares outstanding.
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9. 9. Comparing Value With Market Price
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Should a stock always be bought if DCF value is above market price?
Not necessarily. The assumptions, business quality, balance sheet, and margin of safety should also be evaluated.
What if the market price is close to the DCF value?
The stock may be fairly valued, and the decision may depend on risk tolerance, confidence in assumptions, and alternative opportunities.
Undervalued: A stock may be undervalued when estimated intrinsic value is meaningfully above market price.
Overvalued: A stock may be overvalued when estimated intrinsic value is meaningfully below market price.
Implied upside: The percentage gain from market price to estimated intrinsic value.
Margin of safety: A cushion between estimated value and purchase price to reduce the impact of errors.
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10. 10. Testing Assumptions and Limits
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Which DCF assumption is usually most sensitive?
WACC and terminal growth are often highly sensitive because they strongly affect terminal value, which can be a large part of total value.
How should a beginner avoid false precision in DCF?
Use conservative assumptions, build valuation ranges, compare with market multiples, and require a margin of safety before investing.
Sensitivity analysis: Testing how valuation changes when important assumptions are adjusted.
Scenario analysis: Comparing base, optimistic, and pessimistic cases to understand a range of outcomes.
Model risk: The risk that valuation conclusions are wrong because the model or assumptions are flawed.
Forecast uncertainty: The unavoidable difficulty of estimating future business performance.
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