Discounted Cash Flow (DCF) Valuation

Overview

When to Use

• User needs to value a company or business unit
• User evaluating M&A targets or investment opportunities
• User asks "what's the fair price?" or "build a valuation model"

• For early-stage startups with no revenue → use comparables or venture method
• For quick relative valuation → use multiples (P/E, EV/EBITDA)
• For portfolio-level decisions → use BCG Matrix

Framework

IRON LAW: Garbage In, Garbage Out

DCF output is ONLY as good as its assumptions. Every assumption (growth rate,
margin, WACC, terminal growth) must be explicitly stated with justification.
A DCF without an assumptions table is worthless.

IRON LAW: Terminal Value Dominates — Handle with Care

Terminal value typically represents 60-80% of total DCF value. If your
terminal growth rate exceeds long-term GDP growth (~2-3%), you're implying
the company will eventually become larger than the economy. Cap terminal
growth at the risk-free rate or GDP growth.

Step 1: Project Free Cash Flows (5-10 years)

FCF = EBIT × (1 - Tax Rate) + Depreciation - CapEx - ΔWorking Capital

• Revenue growth assumptions (top-down or bottom-up)
• Operating margin trajectory
• Capital expenditure requirements
• Working capital changes

Step 2: Calculate WACC

WACC = (E/V × Re) + (D/V × Rd × (1 - Tax))

• Re = Cost of equity (use CAPM: Rf + β × Market Risk Premium)
• Rd = Cost of debt (interest rate on borrowings)
• E/V = Equity weight, D/V = Debt weight

Step 3: Calculate Terminal Value

TV = FCF_final × (1 + g) / (WACC - g)

TV = EBITDA_final × EV/EBITDA multiple

Step 4: Discount to Present Value

Enterprise Value = Σ FCFt / (1 + WACC)^t + TV / (1 + WACC)^n
Equity Value = Enterprise Value - Net Debt
Per Share Value = Equity Value / Shares Outstanding

Step 5: Sensitivity Analysis

Output Format

# DCF Valuation: {Company}

## Key Assumptions
| Assumption | Value | Justification |
|-----------|-------|---------------|
| Revenue growth (Y1-5) | X% | {basis} |
| Operating margin (terminal) | X% | {basis} |
| WACC | X% | {calculation} |
| Terminal growth | X% | {basis} |

## Projected Free Cash Flows
| Year | Revenue | EBIT | FCF |
|------|---------|------|-----|
| Y1 | ... | ... | ... |

## Valuation Summary
- PV of FCFs: $X
- PV of Terminal Value: $X (X% of total)
- Enterprise Value: $X
- Less: Net Debt: $X
- Equity Value: $X
- Per Share: $X

## Sensitivity Table
| WACC \ Terminal g | 1.5% | 2.0% | 2.5% |
|-------------------|------|------|------|
| 8% | $X | $X | $X |
| 9% | $X | $X | $X |
| 10% | $X | $X | $X |

Examples

Correct Application

• Projected 5 years of FCF with declining growth (25% → 15%)
• WACC 10.5% (justified: Rf 1.5%, β 1.2, ERP 6%, debt cost 4%)
• Terminal growth 2.5% (Taiwan GDP growth proxy)
• TV = 72% of enterprise value — within normal range ✓
• Sensitivity table shows $X range across ±1% WACC

Incorrect Application

• Terminal growth rate of 8% → Implies the company outgrows the economy forever. Violates Iron Law.
• No assumptions table — just "Enterprise Value = NT$2.5B" → No way to validate. Violates Iron Law.

Gotchas

• Terminal value sensitivity: Small changes in terminal growth or WACC swing valuation 20-30%. Always present a range, not a point estimate.
• Circular reference in WACC: WACC needs equity value (market cap), but DCF calculates equity value. Iterate or use target capital structure.
• FCF vs Net Income: DCF uses Free Cash Flow, not earnings. Companies with high capex or working capital needs can have positive earnings but negative FCF.
• Country risk premium: For Taiwan/emerging market companies, add a country risk premium to WACC (typically 1-3%).
• Negative FCF in early years: Growth companies may have negative FCF initially. This is fine — the value comes from later years and terminal value.

Scripts

scripts/dcf.py

python scripts/dcf.py --help

python scripts/dcf.py --verify

References

• For WACC calculation details, see

  references/wacc-calculation.md

• For comparable company multiples approach, see

  references/comparables.md