Module 6 · DCF Part I: Your First Model Core

The discounted cash flow model is the closest thing investing has to a first-principles valuation: what is a business worth if it's worth the cash it will produce? In this module you'll build one by hand, every line shown, and land on a number you can defend line by line.

Time value of money

A dollar today is worth more than a dollar in five years, because today's dollar can be invested to grow. To compare a future cash flow to today's money, we discount it:

where r is the discount rate and n the number of years away. At an 8.35% rate, a dollar in Year 5 is worth 1 ÷ (1.0835)⁵ = 1 ÷ 1.4934 ≈ $0.670 today. That factor, 0.670, is how much we shrink a Year-5 cash flow. Do this to every future cash flow, add them up, and you have the present value of the whole stream — the essence of a DCF.

What we discount: FCFF

We discount free cash flow to the firm (FCFF) — the cash available to all capital providers, before financing. Discounting FCFF at the WACC gives enterprise value; we then subtract net debt to reach equity value. Take the FCFF → EV → equity path every time, so your numbers stay comparable between companies. (A proper FCFF adds back after-tax interest to CFO − CapEx; use that when the interest line is available, and note which basis you used when it isn't.)

The discount rate: WACC step by step

The right discount rate for FCFF is the weighted average cost of capital — the blended return debt and equity holders together require. Build it in three steps. We'll use a fictional but realistic company, Northbridge Industrial Corp, throughout.

1. Cost of equity (CAPM): risk-free rate + beta × equity risk premium = 3.5% + 1.20 × 5.0% = 9.5%.
2. After-tax cost of debt: pre-tax cost of debt × (1 − tax rate) = 5.0% × (1 − 0.25) = 3.75%. Interest is tax-deductible, so debt is cheaper after tax.
3. Weight by capital structure: Northbridge has $8,000M equity (market cap) and $2,000M debt, so weights are 80% / 20%. WACC = 0.80 × 9.5% + 0.20 × 3.75% = 7.60% + 0.75% = 8.35%.

Projecting free cash flow

Northbridge generated $1,000M of free cash flow last year. We'll project five years growing at 8% (a single, teachable rate here; Module 7 adds fade and scenarios), then discount each year at the 8.35% WACC:

Rule of thumb for the projection: fade growth toward a GDP-like rate. Nobody grows 30% forever; assuming they do is the most common way DCFs lie.

Terminal value

We can't forecast forever, so after Year 5 we capture everything that follows in a single terminal value. Two methods:

• Gordon perpetuity: TV = FCF₅ × (1 + g) ÷ (WACC − g). With FCF₅ = $1,469.33M, terminal growth g = 2.5% and WACC 8.35%: TV = 1,469.33 × 1.025 ÷ (0.0835 − 0.025) = 1,506.06 ÷ 0.0585 = $25,744.6M (measured at the end of Year 5).
• Exit multiple: apply a sector EV/EBITDA to Year-5 EBITDA. Good as a cross-check on the perpetuity.

Discount that terminal value back to today with the Year-5 factor: PV(TV) = 25,744.6 × 0.6697 = $17,240.2M.

Assembling the model

Add the pieces and walk down to a per-share value:

There it is: a first-principles estimate that Northbridge is worth about $41.38 a share. If it trades at $30, the DCF says it's cheap; at $55, expensive. Either way you now have a number you built and understand.