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Discounted Cash Flow Model

Projecting unlevered free cash flow, calculating WACC from first principles, comparing terminal value methods, and building a sensitivity table — with a complete five-year worked model for a $2B industrial company.

The DCF Framework

A discounted cash flow model values a business by estimating the cash flows it will generate over time and discounting them back to today at a rate that reflects the risk of those cash flows. The fundamental insight is that a dollar today is worth more than a dollar tomorrow — and the riskier the business, the more aggressively future cash flows are discounted.

The DCF produces an intrinsic value — what the business is worth based on its economic fundamentals — independent of what the stock market happens to think today. This makes it the most theoretically pure valuation method, but also the most assumption-sensitive. Small changes in the discount rate or terminal value assumptions can move the output by 20–30%.

The structure of every DCF is the same:

1. Project free cash flow over an explicit forecast horizon (typically 5–10 years)
2. Calculate the discount rate (WACC) reflecting the blended cost of the company's capital
3. Discount each year's FCF back to present value
4. Calculate terminal value — the value of all cash flows beyond the forecast horizon
5. Sum PV of FCFs + PV of terminal value to get enterprise value, then bridge to equity value

Step 1: Project Free Cash Flow

We are building a DCF for Hartwell Industrial, a manufacturer of industrial automation components with $2.0B in LTM revenue, a 22% EBITDA margin ($440M EBITDA), and a steady but maturing growth profile. The company has been growing revenue at 6–8% annually and is expected to sustain mid-single-digit growth through the forecast period as it expands internationally.

The free cash flow projection waterfall starts with revenue and works down through EBITDA, taxes, and capital investment items to arrive at unlevered FCF:

A few modeling notes. D&A is added back in the cash flow section because it reduced EBIT but was non-cash — it never left the bank account. Capex is the actual cash investment in property, plant, and equipment. The change in net working capital (NWC) represents cash consumed by the business growing — as revenue increases, receivables and inventory typically grow faster than payables, consuming cash. For Hartwell, NWC consumption tapers as growth decelerates in Years 4–5.

NOPAT — Net Operating Profit After Tax — is the key building block. It represents after-tax operating profit as if the company had no debt (interest is excluded because we are building an unlevered model). NOPAT + D&A − Capex − ΔNWC = Unlevered FCF.

Step 2: Calculate WACC

WACC (Weighted Average Cost of Capital) is the blended discount rate reflecting the return required by all capital providers — equity holders and debt holders — weighted by their respective share of the capital structure. It is the rate at which we discount future FCFs.

Where E = equity value, D = debt value, V = E + D, Ke = cost of equity, Kd = pre-tax cost of debt. Debt gets a tax shield because interest is deductible.

Cost of Equity: CAPM

The cost of equity is estimated using the Capital Asset Pricing Model (CAPM). The model says the required return on equity is the risk-free rate plus a premium for bearing market risk, scaled by how much systematic risk the specific stock carries (beta).

Capital structure weights use market values, not book values. Book value of equity often differs dramatically from market cap — particularly for mature industrial companies with significant accumulated depreciation. Using book equity as a weight understates the equity portion of the capital structure and distorts WACC.

Beta is typically un-levered from the peer group (to strip out each company's individual capital structure), then re-levered at the target company's capital structure. For simplicity here, we use the peer median levered beta directly at Hartwell's capital structure assuming it is representative.

Step 3: Terminal Value — Two Methods

The forecast period captures 5 years of explicit cash flows. But a business does not stop generating value in Year 5 — terminal value captures everything after. In practice, terminal value comprises 65–80% of total DCF value for mature businesses, which is why the assumptions driving it matter enormously.

There are two methods for calculating terminal value: Gordon Growth and Exit Multiple. A well-constructed DCF checks both and reconciles any large discrepancy.

Method 1: Gordon Growth Model (Perpetuity Growth)

The Gordon Growth Model assumes the company grows its free cash flow at a constant rate forever after Year 5. The terminal growth rate should approximate long-run nominal GDP growth — typically 2.0–2.5% for a U.S. industrial company. Using a rate above long-run GDP implies the company eventually becomes larger than the entire economy, which is not defensible.

Method 2: Exit Multiple Method

The exit multiple method applies an EV/EBITDA multiple to Year 5 EBITDA, assuming the company could be sold at that multiple at the end of the forecast period. The multiple should be anchored to current trading comps for the peer group — in this case, 8.5x EBITDA for the industrial automation sector.

Notably, both methods produce nearly identical terminal values ($5,551M vs. $5,534M). This is a strong internal consistency check — when GGM and exit multiple agree, it means the implied perpetuity growth rate embedded in the exit multiple is reasonable. If GGM implied $8,000M but exit multiple implied $4,000M, you would need to investigate which assumption is wrong.

Discounting Terminal Value and FCFs to Present Value

Each cash flow (and the terminal value) is discounted back at WACC using the mid-year convention — the assumption that cash flows arrive at the midpoint of each year rather than at year end. This is more realistic than end-of-year discounting.

Step 4: Bridge to Equity Value

The DCF produces enterprise value — the value of the entire business, regardless of how it is financed. To get equity value per share, we subtract net debt and divide by diluted shares outstanding.

Hartwell's balance sheet: $1,200M total debt (all senior secured term loans), $0 minority interest, $0 preferred stock, $185M cash. Net debt = $1,015M. Diluted shares outstanding: 120M.

If Hartwell is currently trading at $28.50, the DCF suggests the stock is approximately 10% undervalued relative to intrinsic value based on these assumptions. But before drawing any conclusion, you must stress-test those assumptions — which is where sensitivity analysis comes in.

Step 5: Sensitivity Analysis

Because the DCF is highly sensitive to the discount rate and terminal growth assumptions, bankers always include a sensitivity table showing how the implied share price changes as these inputs vary. The two most important drivers are WACC and the terminal growth rate (or exit multiple).

The table below shows implied equity value per share at WACC ranging from 8.0% to 10.5% and terminal growth rates from 1.5% to 3.5%. The base case (9.22% WACC, 2.5% growth) is highlighted.

The sensitivity table shows a wide range: from $22.51 (WACC 10.5%, g=1.5%) to $53.60 (WACC 8.0%, g=3.5%). This is not a model error — it is the honest answer. The DCF is saying: "if these assumptions are right, the stock is worth this much. Here is how sensitive that conclusion is." A banker presenting a DCF without a sensitivity table is hiding the uncertainty that is always present.

The key observation: moving from the base case to the 10.5% WACC scenario drops the implied price by 20%. A 1% increase in WACC has more impact on value than almost any operating assumption. This is why WACC is always a first point of scrutiny in any valuation review.

Where DCF Breaks Down