Discounted Cash Flow (DCF) valuation calculates enterprise value by projecting future free cash flows (FCF) and discounting them to present value using Weighted Average Cost of Capital (WACC).

Formula: Enterprise Value = Σ(FCF_t / (1+WACC)^t) + Terminal Value / (1+WACC)^n. 2025 example: Company with $10M Year 1 FCF growing 5% annually, 10% WACC, 2.5% terminal growth → PV of 5-year FCFs = $10M/(1.1) + $10.5M/(1.1)^2 + ... = $37.9M.

Terminal Value = $11.6M × (1.025) / (0.10 - 0.025) = $158.3M.

PV of Terminal = $158.3M/(1.1)^5 = $98.3M.

Total Enterprise Value = $37.9M + $98.3M = $136.2M.

Subtract net debt to get equity value, divide by shares for intrinsic price per share.

Two methods (2025): (1) Gordon Growth Model (Perpetuity) - assumes constant growth forever: Terminal Value = FCF_final × (1+g) / (WACC - g), where g = long-term growth rate (typically 2-3% matching GDP).

Example: Year 5 FCF = $15M, g=2.5%, WACC=9% → $15M×1.025/(0.09-0.025) = $236.5M. (2) Exit Multiple - applies industry EV/EBITDA multiple: Terminal Value = EBITDA_final × Exit Multiple.

Example: Year 5 EBITDA = $25M, Tech industry 10x multiple → $250M Terminal Value.

Rule of thumb: Terminal Value typically represents 60-80% of total enterprise value.

Sensitivity test: If g=2% vs 3%, Terminal Value changes 20-30%.

Use WACC > terminal growth rate (WACC must exceed g, or formula breaks - negative denominator).

WACC (Weighted Average Cost of Capital) = (E/V × Cost of Equity) + (D/V × Cost of Debt × (1-Tax Rate)). 2025 calculation: (1) Cost of Equity (CAPM): Risk-free rate (10-yr Treasury 4.5%) + Beta × Market Risk Premium (6-8%) = 4.5% + 1.2 × 7% = 12.9%. (2) Cost of Debt: Average interest rate on debt 6%, Tax rate 21% → 6% × (1-0.21) = 4.74%. (3) Capital structure: 70% equity, 30% debt → WACC = 0.70×12.9% + 0.30×4.74% = 9.03% + 1.42% = 10.45%.

Industry benchmarks (2025): Tech startups 12-18%, Mature tech 8-12%, Consumer goods 7-10%, Utilities 5-8%.

Higher risk = higher WACC = lower valuation.

Use target capital structure (not current) if company plans to change debt levels.

Sensitivity analysis: ±2% WACC changes valuation ±25-30%.

Free Cash Flow (FCF) = EBIT × (1 - Tax Rate) + Depreciation & Amortization - Capital Expenditures - Change in Net Working Capital. 2025 projection steps: (1) Revenue growth: Year 1-3 high growth 15-25%, Year 4-5 mature 5-10%, based on historical CAGR and market opportunity. (2) EBIT margin: Improve from current 15% to target 20% over 5 years as scale increases. (3) D&A: 3-5% of revenue typically. (4) CapEx: Growth companies 8-12% of revenue, mature 3-5%. (5) Working capital: Growing companies need more (10-15% of revenue growth), mature companies stable.

Example: Year 1 Revenue $100M (20% growth), 18% EBIT margin = $18M EBIT, tax 21% = $14.2M NOPAT, +$3M D&A, -$10M CapEx, -$2M WC increase = $5.2M FCF.

Sanity check: FCF margin 5-15% of revenue typical for healthy companies.

2025 pitfalls: (1) Overly optimistic growth - projecting 30% annual growth for 10 years (only 0.1% of companies achieve this).

Use industry growth rates + 2-5% max. (2) Terminal growth > GDP - using 5% when US GDP grows 2-3% implies company becomes 100% of economy.

Cap at 2.5-3%. (3) Ignoring cyclicality - using peak-year cash flows for cyclical industries (semiconductors, construction).

Normalize to mid-cycle. (4) Wrong capital structure - using book value debt/equity instead of market value. (5) Forgetting minority interests, preferred stock when calculating equity value. (6) WACC < terminal growth rate - mathematically impossible, creates negative denominator. (7) Double-counting - adding back stock-based compensation to FCF if already in EBIT. (8) Mis-estimating Beta - using 5-yr Beta for recently public company (use industry Beta).

Rule: DCF valuation most reliable for mature, predictable companies (P&G, Visa).

Less reliable for startups, turnarounds, commodity businesses.

2025 decision framework: (1) Calculate intrinsic value per share: (Enterprise Value - Net Debt - Minority Interest - Preferred Stock) / Diluted Shares Outstanding.

Example: EV $500M, Net Debt $100M, 20M shares → Intrinsic value = ($500M-$100M)/20M = $20/share. (2) Compare to market price: Current $15/share → 33% upside (buy signal if >20%). (3) Margin of Safety: Value investors require 30-50% discount (intrinsic $20, buy only below $13-$14). (4) Sensitivity analysis: Test WACC ±2%, terminal growth ±1%, FCF growth ±5%.

If intrinsic value ranges $15-$25 across scenarios, high uncertainty - require larger margin. (5) Triangulate with other methods: P/E ratio, EV/EBITDA multiples, DDM for dividend stocks.

If DCF says $20 but all comps trade at 15x EBITDA = $12, re-examine assumptions. (6) Update quarterly: DCF is point-in-time estimate, refresh after earnings with new guidance.

Use DCF for long-term (3-5 year) intrinsic value, not short-term trading.

Best for: fundamental analysis, M&A target prices, capital budgeting decisions.