Financial Models

Building a Discounted Cash Flow (DCF) Model: A Step-by-Step Guide

Finance Guy

Finance Guy

— 3 min read

A Discounted Cash Flow (DCF) model is the gold standard for valuing businesses, projects, or assets.

By forecasting future cash flows and discounting them to today’s dollars, it helps investors determine whether an opportunity is undervalued or overvalued.

In this guide, we’ll break down how to build a DCF model from scratch, including calculating free cash flow, discount rates, terminal value, and interpreting results. Let’s dive in!

Step 1: Calculate Free Cash Flow (FCF)

Free Cash Flow (FCF) represents the cash a company generates after covering operating expenses and capital expenditures. It’s the lifeblood of the DCF model.

Formula:

FCF = Operating Cash Flow (OCF) - Capital Expenditures (CapEx) - Changes in Working Capital (NWC)

Breaking it down:

  1. Operating Cash Flow (OCF): OCF = EBIT × (1 - Tax Rate) + Depreciation & Amortization
  2. CapEx: Cash spent on long-term assets (e.g., machinery, buildings)
  3. Changes in Working Capital (NWC): Fluctuation in a company's short-term financial position

Example:

  • EBIT = $10M
  • Tax Rate = 25% → After-tax EBIT = $7.5M
  • Depreciation = 2M→7.5M + 2M=$9.5M
  • CapEx = 3M→9.5M - 3M=$6.5M
  • NWC = 1.5M→6.5M - 1.5M=$5.0M

Step 2: Calculate the Discount Rate (WACC)

The Weighted Average Cost of Capital (WACC) reflects the blended cost of debt and equity. It’s used to discount future cash flows to their present value.

Formula:

WACC = (E/V × Re) + (D/V × Rd)

  • E = Market value of equity
  • D = Market value of debt
  • V = Total value (E + D)
  • Re = Cost of equity (Use CAPM)
    • CAPM: (Equity Risk Premium x Beta) + Risk-Free Rate
    • Equity Risk Premium = Expected Market Return - Risk-Free Rate
  • Rd = Cost of Debt (After Tax)
    • Interest rate on debt × (1 - Tax Rate)

Example:

  • Equity = 60M, Debt=40M → V = $100M
  • Re = 10%, Rd(After-Tax) = 5%
  • WACC = (60% × 10%) + (40% × 5%) = 8.0%

Step 3: Discount Future Cash Flows

Project FCF for 5–10 years and discount each year’s cash flow to present value using WACC.

Formula:

PV of FCF in Year n = FCF_n / (1 + WACC)^n

Example:

  • Year 1 FCF = 5.0M→PV=5.0M / (1 + 8.0%)^1 = $4.63M
  • Year 2 FCF = 6.0M→PV=6.0M / (1 + 8.0%)^2 = $5.14M
  • ...Repeat for all forecasted years.

Total PV of Cash Flows: Sum the present values of all projected FCFs.

Step 4: Calculate Terminal Value (TV)

The terminal value captures the value of cash flows beyond the forecast period. Two common methods:

1. Perpetuity Growth Rate

Assume FCF grows at a constant rate (g) forever.

Formula:

TV = (FCF_YearN × (1 + g) / (WACC - g))

  • FCF_YearN = Final year’s projected FCF
  • g = Conservative long-term growth rate (e.g., 2–3%, close to GDP growth)

Example:

  • Year 5 FCF = $8.5M, g = 2.5%
  • TV = 8.5M × (1 + 2.5%) / (8.0% - 2.5%) = 158.4
  • PV of TV = 158.4M / (1 + 8.0%)^5 = $107.8

2. EBITDA Multiple

Assume the business is sold at a multiple of its final-year EBITDA.

Formula:

TV = EBITDA_YearN × Exit Multiple

  • Exit Multiple: Based on industry averages (e.g., 6x–10x EBITDA).

Example:

  • Year 5 EBITDA = $12M, Exit Multiple = 10x
  • TV = 12M × 10 = 120M
  • PV of TV = 120M / (1 + 8.0%)^5 = $81.7

Step 5: Calculate Firm Value

Add the present value of cash flows and terminal value to get total firm value.

Formula:

Firm Value = PV of Cash Flows + PV of Terminal Value

Example:

  • PV of Cash Flows (5 years) = $32M
  • PV of TV (Perpetuity Growth) = $32M + 107.8M → Total Firm Value = 139.8M
  • PV of TV (EBITDA Multiple) = $32M + 81.7M → Total Firm Value = 113.7M

Interpreting Results: Net Present Value (NPV)

NPV compares the firm value to the initial investment (e.g., equity purchase price or project cost).

Rules:

  1. NPV > 0: The investment is undervalued. Proceed.
  2. NPV = 0: The investment is fairly valued. Non-financial factors may drive the decision.
  3. NPV < 0: The investment is overvalued. Avoid.

Example:

  • Firm Value = $139.8M
  • Initial Investment = 100M→NPV = 39.8M (Good investment!)

Key Considerations

  1. Sensitivity Analysis: Test how changes in WACC, growth rates, or exit multiples impact firm value.
  2. Assumption Quality: Overly optimistic growth or low discount rates inflate valuations.
  3. Terminal Value Dominance: Often 70%+ of total value—handle with care!

Conclusion
A DCF model is a powerful tool, but its accuracy hinges on realistic assumptions.

By mastering FCF, WACC, terminal value, and NPV, you’ll unlock the ability to value businesses with confidence.

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