Key Takeaways
- Build a DCF by projecting unlevered free cash flow, discounting by WACC, and adding a terminal value to estimate intrinsic equity value.
- Use a bottoms-up forecast for revenue and margins, translate to FCFF with clear assumptions for capex, D&A, and working capital.
- Estimate WACC using CAPM for cost of equity and market data for cost of debt, then apply a realistic capital structure.
- Terminal value drives much of the result, so test both Gordon growth and exit multiple approaches with sensitivity analysis.
- Document assumptions, stress-test growth and margins, and reconcile modeled valuation to market comparables for sanity checks.
Introduction
Financial modeling 101 covers the mechanics of building a simple stock valuation model using a discounted cash flow framework. This is the foundation analysts use to convert forecasts into an intrinsic per-share value you can compare to market prices.
Why should you care, if you're already trading or analyzing companies? Because a rigorous DCF forces you to quantify growth drivers, margin assumptions, capital needs, and risk. It reveals which assumptions move value most, and it helps you separate narrative from economically sensible projections. What will you learn? How to forecast income and cash flows step-by-step, estimate WACC, compute terminal value, and run basic sensitivity analysis.
1. Model structure and key definitions
Start by choosing the model endpoint and the cash flow metric. For a valuation that aims to be broadly comparable across capital structures, use unlevered free cash flow, often called FCFF. You'll discount these cash flows at WACC to derive enterprise value, then subtract net debt to reach equity value.
Key definitions you must track precisely: revenue, operating income or EBIT, depreciation and amortization, capital expenditures, change in net working capital, tax rate, and free cash flow to the firm. Be explicit with timing assumptions, fiscal year basis, and units.
Why unlevered cash flow?
Unlevered cash flow isolates operating performance from financing choices. That lets you value the business independent of its debt level, then apply the current or target capital structure to derive equity value. If you want to value an acquisition or compare firms with different leverage, FCFF is preferable.
2. Projecting the income statement and cash flows
Forecasting starts with revenue. For advanced users, build a bottom-up revenue model that links products, channels, or geographies to growth rates. If you lack product detail, use a top-down approach with market size, share gains, or historical CAGR as inputs.
Once revenue is projected, translate it to operating cash flow by applying margins and non-cash items. Keep assumptions granular enough to be believable, and never let the terminal year be your only pillar for growth.
Step-by-step projection
- Revenue forecast: choose a base year, then apply explicit year-by-year growth rates for five to ten years.
- Gross and operating margins: project gross margin drivers like mix and pricing, then model SG&A and R&D to derive EBITDA and EBIT.
- Depreciation and amortization: tie D&A to prior capex and useful lives, avoid flat D&A unless justified.
- Capex: forecast as an amount or as a percent of revenue, aligned with growth and asset intensity.
- Working capital: model components—receivables, inventory, payables—as days of sales or as percent of revenue, then compute annual change in net working capital.
- Calculate FCFF: FCFF = EBIT*(1 - tax rate) + D&A - Capex - Change in NWC.
Illustrative example
Suppose you model a hypothetical technology firm, presented as $AAPL for illustration only, with starting revenue of $100 billion and an expected compound annual growth rate of 6% for five years. Assume operating margin is 25%, D&A is 3% of revenue, capex averages 4% of revenue, and change in NWC is 0.5% of revenue annually. With a 21% tax rate, the first-year FCFF calculation looks like this:
- Revenue: $100.0B
- EBIT: 25% of revenue = $25.0B
- EBIT after tax: $25.0B * 0.79 = $19.75B
- D&A: 3% of revenue = $3.0B
- Capex: 4% of revenue = $4.0B
- Change in NWC: 0.5% of revenue = $0.5B
- FCFF = 19.75 + 3.0 - 4.0 - 0.5 = $18.25B
Repeat for each forecast year, adjusting growth and margin assumptions where justified. Document each driver so you can revisit them later.
3. Estimating discount rate: WACC
WACC is the weighted average cost of capital, used to discount FCFF. It blends the cost of equity and cost of debt, weighted by the firm s target or current capital structure, and adjusted for taxes on debt. You must estimate each component carefully because small changes in WACC materially affect valuation.
Cost of equity using CAPM
Use the capital asset pricing model, Cost of equity = Risk-free rate + Beta * Equity risk premium. For the risk-free rate use a long-term government yield, like the 10-year Treasury. For beta, use an industry-adjusted beta or an average of peers. Equity risk premium is typically between 4% and 6% depending on your market view.
Cost of debt and capital structure
Cost of debt is the market yield on the company s debt or an estimated borrowing rate, adjusted for default risk. Use the effective tax rate to convert pre-tax cost of debt to after-tax cost, since interest is tax-deductible. Weights should reflect market value proportions of debt and equity if possible, otherwise book values can be a proxy for mature firms.
Example WACC calculation
Using our $AAPL illustration assume:
- Risk-free rate = 3.5%
- Beta = 1.1
- Equity risk premium = 5%
- Cost of equity = 3.5% + 1.1 * 5% = 9.0%
- Cost of debt pre-tax = 3.5%
- Tax rate = 21%, after-tax cost of debt = 2.765%
- Target capital structure: 80% equity, 20% debt
WACC = 0.8 * 9.0% + 0.2 * 2.765% = 7.72% approximately. Use this to discount projected FCFF.
4. Terminal value and enterprise value
Terminal value captures cash flows beyond the explicit forecast. Two common methods are the Gordon growth model and an exit multiple approach. Because terminal value often accounts for 50% or more of total enterprise value, choose and test this assumption carefully.
Gordon growth method
Terminal value = FCFF_n * (1 + g) / (WACC - g). Use a conservative long-term growth rate g, typically below long-run GDP growth. For most developed-market companies, choose g between 1% and 3% unless you have strong evidence to justify higher growth.
Exit multiple method
Apply a realistic EV/EBIT or EV/EBITDA multiple based on peer group trading multiples. This method can be useful when industry comparables are stable, but it indirectly embeds the market s expectation of long-term growth and margins.
Putting it together
Discount all explicit-period FCFF and the terminal value back to present value using WACC. Sum those present values to get enterprise value. Subtract net debt to get equity value. Divide by diluted shares outstanding to obtain an intrinsic per-share value. Make it clear that this is a model output, not a recommendation.
5. Sensitivity analysis and scenario planning
Because valuation is assumption-driven, perform sensitivity analysis on key levers: revenue growth, operating margins, WACC, and terminal growth. Build a sensitivity table showing intrinsic value across a grid of WACC and terminal growth values, or growth and margin scenarios.
Also construct at least three scenarios: base case, bull case, and bear case. For each, document the economic rationale and the probability you assign, then compute a probability-weighted fair value if you use a probabilistic approach.
Practical sensitivity example
Using the $AAPL illustration, test WACC at 6.5%, 7.7%, and 9.0% and terminal growth at 1.0%, 2.0%, and 3.0%. Note how intrinsic value changes. If a small change in terminal growth moves value dramatically, that tells you the model is sensitive and you should rely more on explicit-period assumptions and comparables.
Common Mistakes to Avoid
- Ignoring working capital dynamics: Small NWC assumptions can materially change free cash flow, especially for capital-light businesses. Model receivables and payables explicitly, and tie them to sales and gross margin drivers.
- Using unrealistic terminal growth rates: Avoid terminal growth above long-term nominal GDP for mature companies. Higher g increases terminal value nonlinearly, and it often hides unrealistic assumptions in earlier years.
- Misestimating WACC components: Using inconsistent risk-free rates or peer betas can lead to mispriced discount rates. Use market-based inputs and document your choices.
- Forgetting share count dilution: Options, RSUs, and convertible instruments dilute equity. Use diluted share count or model option exercise and share issuance explicitly.
- Overfitting historical data: Don t assume past linear trends will persist. Tie forecasts to drivers like market share, product cycles, and capex plans.
FAQ
Q: How many forecast years should I include in a DCF?
A: Include enough explicit years to capture the company s growth phase and any near-term investment cycle, typically five to ten years. Fast-growing companies may require longer explicit forecasts, while stable firms can often be modeled with five years plus a terminal value.
Q: Should I use nominal or real rates for WACC and terminal growth?
A: Use nominal rates consistently. If you project revenues and cash flows in nominal terms, use a nominal WACC and a nominal terminal growth rate. Mixing real and nominal assumptions will produce incorrect valuations.
Q: When is an exit multiple better than Gordon growth?
A: An exit multiple can be useful when there is a stable peer group with reliable trading multiples and when the business is cyclical, making a single long-term growth rate less informative. Always use both methods as a cross-check where possible.
Q: How do I choose the equity risk premium and beta?
A: Choose an equity risk premium based on long-run historical averages and your market view, typically 4% to 6% for developed markets. For beta, use a raw beta from a regression and consider adjusting it toward the industry average or applying a levered/unlevered adjustment based on your target capital structure.
Bottom Line
A simple DCF model turns qualitative judgment into quantitative outputs, and it forces you to document the drivers behind valuation. By projecting revenue, margins, capex, and working capital, computing FCFF, estimating WACC, and testing terminal value assumptions, you create a repeatable framework for valuing equities.
Next steps: build a clean spreadsheet with an assumptions block, construct explicit-year projections, compute FCFF line by line, estimate WACC from market inputs, and run sensitivity tables. Always reconcile your DCF to comparables and to the economic story you believe in, because at the end of the day the model is only as good as its assumptions.
