Welcome to the Discounted Cash Flow model! The DCF is a fundamental valuation method that determines an investment's worth by projecting its future cash flows and discounting them back to present value. The core principle is simple: money received today is more valuable than the same amount received in the future due to inflation and opportunity cost.
The Discounted Cash Flow model is a fundamental valuation method used to determine the intrinsic value of an investment. It works by projecting all future cash flows and then discounting them back to present value, accounting for the time value of money. This approach recognizes that a dollar received today is worth more than a dollar received in the future.
The first step in DCF modeling is projecting Free Cash Flows. We start with EBIT, subtract taxes, add back non-cash expenses like depreciation, then subtract capital expenditures and changes in working capital. This gives us the cash flow available to all investors. Notice how our projected FCF grows from 110 million in year 1 to 161 million in year 5, reflecting expected business growth.
The second step is determining the appropriate discount rate, typically the Weighted Average Cost of Capital or WACC. WACC represents the company's blended cost of financing, combining the cost of debt and equity weighted by their proportions in the capital structure. A higher WACC reflects higher risk and results in lower present values. In our example, we'll use a WACC of 10 percent.
Step three involves calculating the present value of each projected cash flow. We divide each future cash flow by one plus WACC raised to the power of the year. Notice how each year's 100 million plus in cash flow becomes worth exactly 100 million in present value terms due to our 10% discount rate. The terminal value, representing cash flows beyond year 5, contributes the largest portion at 1.1 billion dollars.
Our DCF analysis yields an enterprise value of 1.599 billion dollars. After subtracting net debt of 200 million, we arrive at an equity value of 1.399 billion. With 100 million shares outstanding, this gives us a fair value of 13.99 dollars per share. Notice that the terminal value represents 69% of the total enterprise value, highlighting the importance of long-term assumptions in DCF modeling.
The terminal value captures the company's worth beyond our explicit forecast period and typically represents 60 to 80 percent of total enterprise value. The perpetuity growth model assumes cash flows grow at a constant rate forever. Using our example with year 5 FCF of 161 million, a 3% growth rate, and 10% WACC, we get a terminal value of 2.37 billion dollars. Notice how sensitive this value is to our assumptions about growth and discount rates.
Step three involves discounting all future cash flows to present value using our WACC of 10 percent. Each year's cash flow is divided by one plus WACC raised to the power of that year. For example, year 5's cash flow of 161 million becomes 100 million in present value terms. The terminal value of 2.37 billion discounts to 1.47 billion. Summing everything gives us an enterprise value of 1.97 billion dollars.