New on FinoLib · Volume II: Capital Markets
I have just published a new article on FinoLib, my free finance education library: Discounted Cash Flow (DCF): Formula, Steps and Example. It is part of Volume II: Capital Markets. Below is a summary of the topic in plain, expert language, so you can follow the idea even before you open the full article.
The idea in plain words
A DCF answers one question: what is this business worth today, based on the cash it will produce? First forecast the free cash flow, which is the cash left after running costs, taxes and investment. Then shrink each future year back to today using a discount rate. Add a terminal value to cover the years beyond the forecast, and subtract debt to reach the value that belongs to shareholders. For the example company, Harbor Tools, this gives $15.24 a share with one terminal method and $13.78 with another.
Key points
■Terminal value supplied 78% of Harbor’s enterprise value, so its assumptions deserve the most scrutiny.
■The mid-year convention raised enterprise value by 4.2%; Gordon terminal value is discounted N − 0.5 years, an exit-multiple value N years.
■A 3×3 sensitivity table showed $11.26 to $22.20 a share; it varies one DCF’s inputs and is not the football field of Section 1.10: Triangulating Valuation — Putting It All Together.
■Growth must be paid for with reinvestment: the same 4% terminal growth is worth $11.27 or $18.96 a share depending on the return new capital earns.
A closer look
A DCF values a business as the present value of all the cash it will generate for its owners in the future. Building one, in practice, moves through five stages:
Read the output as a range, $13.78 to $15.24 a share. Terminal value supplies 78% of the Gordon value, so its assumptions deserve the most scrutiny.
A worked example
Worked Example — A Five-Year DCF, Start to Finish
Harbor Tools Inc. is an illustrative US maker of industrial hand tools (USD millions except per share). Input Value Revenue, Year 0 $1,000.0 Revenue growth, Years 1–5 8%, 7%, 6%, 5%, 4% EBIT margin / tax rate (t) 14% / 25% (21% federal + 4% assumed state) D&A / capex / net working capital (NWC) 4% / 5% / 12% of revenue WACC (Sections 1.4 and 1.5) 8.5% Terminal growth (g) / exit multiple 3.0% / 9.0x EBITDA (assumed peer level) Debt / cash / diluted shares $600.0 / $100.0 / 100.0 million Step 1, free cash flow, starts from operating profit, because a DCF at WACC values the business for all investors.
Decision rule
Set terminal growth at or below long-run nominal GDP growth (about 4% for the US) and no higher than your reinvestment supports: g = reinvestment rate × RONIC, the return on new invested capital. If terminal value exceeds about 85% of enterprise value, lengthen the forecast. Run both terminal methods; if they differ by more than about 15%, reconcile the implied multiple and growth first. Both triggers are heuristics; early-stage companies breach the first.
The costliest mistake
Letting terminal growth come for free. Harbor reinvests 18.6 of its 144.7 Year-6 NOPAT (12.85%) to grow 3%, which implies RONIC = 3.0% ÷ 12.85% = 23.3%. Raise g to 4% with no extra reinvestment and value jumps from $15.24 to $18.96 (+24%); paying for that growth at 23.3% gives $18.00. If competition pulls RONIC down to the WACC, growth adds nothing: TV = NOPAT₆ ÷ WACC. At 4% growth NOPAT₆ is 146.1, so TV = 1,718.5, worth $11.27 a share, barely above the $11.16 at 3%. One unstated assumption spans $11.27 to $18.96 at the same 4% growth.
Why It Matters
Because terminal value dominates the total, a DCF’s output is extremely sensitive to two inputs: the discount rate and the long-term growth rate. In the worked example below, moving growth from 2% to 3% raises value per share by 19%, and cutting the discount rate from 9% to 8% raises it by 27%.
Recap
A DCF discounts unlevered free cash flow at the WACC, adds a terminal value by Gordon growth or an exit multiple, and bridges to equity value; Harbor Tools comes out at $13.78 to $15.24 a share, with 78% of value in the terminal value. Mid-year discounting, a sensitivity table and a reinvestment-consistent terminal year are standard practice.
What the full article covers
The full article includes worked examples, a clear decision rule, the one mistake that costs people the most, a recap, a reveal-on-click quiz and the official sources behind every figure.
Volume II: Capital Markets
Read the full article on FinoLib
The complete article, Discounted Cash Flow (DCF): Formula, Steps and Example, with every worked example, diagram, quiz and source, is free to read in Volume II, Capital Markets on finolib.com.
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