BA-302 · Lesson 6 of 9

The Discounted Cash Flow (DCF) Method

You build a simplified DCF valuation with WACC, a terminal value and a sensitivity analysis.

18 min read Advanced Valuing Listed Companies
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BA-301 · Financial Statement AnalysisThe Balance Sheet: Assets, Liabilities and EquityThe Income StatementThe Cash Flow Statement
BA-302 · Valuing Listed CompaniesProfitability and Leverage RatiosMarket MultiplesThe Discounted Cash Flow (DCF) Method
BA-303 · Portfolio ManagementDiversification and Asset AllocationMeasuring RiskBuilding and Rebalancing a Portfolio

The principle of intrinsic value

The DCF method (Discounted Cash Flow) starts from the idea that the value of a business equals the present value of the cash flows it will generate in the future. One leu received five years from now is worth less than one leu today, because of both opportunity cost and risk. That is why future cash flows are discounted at a rate that reflects their risk.

Free cash flow to the firm
FCFF = EBIT × (1 − t) + Depreciation and amortization − CAPEX − Increase in working capital
t is the income tax rate. For Nistru Agro SA in the current year: 10,000 × 0.88 + 3,000 − 5,000 − 1,540 = MDL 5,260 thousand (illustrative).

The discount rate: a simplified WACC

Weighted average cost of capital
WACC = wE × kE + wD × kD × (1 − t)
wE and wD are the weights of equity and debt in the financing structure (preferably at market or target values); kE is the cost of equity and kD is the pre-tax cost of debt.

The cost of debt can be estimated from the interest rate at which the company borrows. The cost of equity is harder to observe: it is the return shareholders require and is usually estimated as a risk-free rate plus a risk premium appropriate to the company. For investors working in Moldovan lei (MDL), the rates must be expressed in the same currency as the cash flows.

Terminal value and the full calculation

Terminal value (Gordon growth model)
TV(n) = FCFF(n) × (1 + g) ÷ (WACC − g); Present value = Cash flow(t) ÷ (1 + WACC)^t
g is the perpetual growth rate and must be strictly lower than WACC; over the long term, it should not exceed the plausible nominal growth of the economy.
Item (MDL thousand, illustrative)Year 1Year 2Year 3
Projected FCFF6,0006,5007,000
Discount factor at 13%0.88500.78310.6931
Present value5,309.75,090.54,851.4
  1. Sum of the explicit present values5,309.7 + 5,090.5 + 4,851.4 ≈ MDL 15,251.5 thousand (the difference of 0.1 is due to rounding).
  2. Terminal value at the end of year 3With g = 4%: 7,000 × 1.04 ÷ (0.13 − 0.04) = 7,280 ÷ 0.09 ≈ MDL 80,888.9 thousand.
  3. Discounting the terminal value80,888.9 × 0.6931 ≈ MDL 56,060.1 thousand (calculated with the exact factor 1 ÷ 1.13³).
  4. Enterprise valueEV = 15,251.5 + 56,060.1 = MDL 71,311.6 thousand.
  5. Value per shareEquity = 71,311.6 − 19,700 (net debt) = MDL 51,611.6 thousand; per share = 51,611,600 ÷ 2,000,000 ≈ MDL 25.81.

Notice that the discounted terminal value accounts for roughly 56,060.1 ÷ 71,311.6 ≈ 78.6% of EV. Such a large share is typical and shows why long-term assumptions matter more than detailed forecasts for the first few years. In practice, the explicit forecast period is usually five to ten years; three years are used here for simplicity.

Sensitivity analysis

Value per share (MDL)g = 3%g = 4%g = 5%
WACC = 12%26.4230.3035.28
WACC = 13%22.7625.8129.61
WACC = 14%19.7722.2125.21

Changes of just ±1 percentage point in WACC and g move the estimated value from about MDL 19.77 to MDL 35.28 per share — a difference of more than 78%. In addition, net debt amplifies the variation at the equity level. That is why a DCF result should be presented as a range, not as a single value.

Key takeaways

  • DCF estimates intrinsic value by discounting future cash flows at a rate that reflects their risk.
  • FCFF is discounted at WACC; net debt is subtracted from EV to arrive at equity value.
  • The terminal value often makes up most of the total value, so long-term assumptions are critical.
  • The perpetual growth rate must be lower than WACC and economically plausible.
  • The result should be presented as a range, accompanied by a sensitivity analysis.

Check your knowledge

Answer all the questions. If you answer all of them correctly, the lesson is marked as completed automatically.

Question 1 of 3What is the terminal value at the end of year 3 if FCFF in year 3 is MDL 7,000 thousand, WACC = 13% and g = 4%?

Explanation: TV = 7,000 × 1.04 ÷ (0.13 − 0.04) = 7,280 ÷ 0.09 ≈ MDL 80,888.9 thousand.

Question 2 of 3kE = 14%, kD = 10%, t = 12%, wE = 80%, wD = 20%. What is WACC?

Explanation: WACC = 0.80 × 14% + 0.20 × 10% × (1 − 0.12) = 11.2% + 1.76% = 12.96%.

Question 3 of 3What happens to the DCF-estimated value if WACC rises, with all other assumptions unchanged?

Explanation: A higher discount rate reduces the present value of all cash flows, including the terminal value.

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Educational material only. It does not constitute investment, legal or tax advice. Numerical examples are hypothetical.