How the model is built
Free cash flow is the cash left after the business pays its operating costs, taxes and the investment it needs to keep running. The model discounts each of the five forecast years at the WACC. Everything after year 5 is packed into a single terminal value, which treats the cash flow as growing at a steady rate forever.
EV = FCF1/(1+WACC) + ... + FCF5/(1+WACC)^5 + TV/(1+WACC)^5, where TV = FCF5 x (1+g) / (WACC - g). Equity value = EV - net debt. Value per share = equity value / shares outstanding. This is the standard Gordon growth form of a DCF found in valuation textbooks.
A worked example
A company forecasts free cash flow of $120, $132, $145, $157 and $168 million over the next five years. The WACC is 9%, long-run growth is 2.5%, net debt is $300 million and there are 50 million shares. All figures are invented for teaching.
| Item | Amount | Present value |
|---|---|---|
| Year 1 free cash flow | $120.00 | $110.09 |
| Year 2 free cash flow | $132.00 | $111.10 |
| Year 3 free cash flow | $145.00 | $111.97 |
| Year 4 free cash flow | $157.00 | $111.22 |
| Year 5 free cash flow | $168.00 | $109.19 |
| Terminal value at year 5 | $2,649.23 | $1,721.82 |
| Enterprise value | $2,275.39 |
The terminal value is $168 x 1.025 / 0.065 = $2,649.23 million, worth $1,721.82 million today. Enterprise value is $2,275.39 million. Subtract $300 million of net debt for an equity value of $1,975.39 million, or $39.51 a share. About three quarters of the value comes from the terminal value, which is typical and is the first thing to question in any DCF.
Reading the sensitivity table
The grid under the result reruns the model with the WACC one point lower and higher, and growth one point lower and higher. In the example, the value per share runs from $29.69 (10% WACC, 1.5% growth) to $57.98 (8% WACC, 3.5% growth). That spread is the honest answer to how precise a DCF is. A one-point change in either input moves the value by several dollars a share.
Pick the growth rate with care. It should not exceed the long-run growth of the economy the company sells into, and it must stay below the WACC or the formula breaks down. The calculator refuses growth at or above WACC and says why. Cash flows are assumed to arrive at the end of each year; a mid-year convention would raise the value slightly.
Mistakes that cost points
- Using net income instead of free cash flow. Depreciation, capital spending and working capital all change cash.
- Setting terminal growth at or above the discount rate, which makes the terminal value meaningless.
- Discounting the terminal value by four years instead of five. It sits at the end of year 5 and gets the same factor as year 5.
- Subtracting only debt and forgetting cash. Net debt is debt minus cash.
- Treating one answer as exact. Show the range from the sensitivity table.
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