FINM3005 · Corporate Valuation
DCF Valuation Foundations
Discounted cash flow (DCF) is the engine the whole of FINM3005/6005 runs on, and this chapter is its centrepiece. An asset is worth the present value of the cash it will generate, so a DCF discounts each year's free cash flow to the firm (FCFF) at the WACC, adds a terminal (continuing) value for the firm's life beyond the forecast, and sums the present values to an enterprise value. From there the EV→equity bridge subtracts net debt and minority interest to reach equity value, which you divide by shares to get value per share. The chapter also fixes the conceptual scaffolding the exam probes: intrinsic vs book vs market value, the four valuation approaches (DCF, multiples, contingent-claim, asset-based), the value-creation rule that value is created only when ROIC > WACC, and the three ways to estimate terminal value (convergence, Gordon/key-value-driver, exit multiple). Get this picture cold and every later week — reorganising the accounts, forecasting, building the WACC, growth, multiples — is a sub-routine that feeds this one diagram.
What this chapter covers
- 01The valuation mindset: intrinsic vs book vs market value
- 02The four valuation approaches and where DCF sits
- 03The value-creation engine: g = reinvestment × ROIC, value only when ROIC > WACC
- 04The DCF in one picture: PV(FCF) + PV(TV) = EV → equity bridge
- 05FCFF vs FCFE and the six-step enterprise DCF
- 06Terminal value three ways: convergence, Gordon/KVD, exit multiple
- 07A fully worked DCF on a stylised company, mark by mark
Worked example: a one-page enterprise DCF, EV to value per share
- +1(a) Continuing value. With RONIC = WACC, growth adds nothing, so use the convergence form CV₃ = NOPLAT₄ ÷ WACC = 63 ÷ 0.09 = $700m, dated at end of year 3.
- +1Discount factors at 9%: 1/1.09 = 0.917, 1/1.09² = 0.842, 1/1.09³ = 0.772.
- +1PV of explicit FCFF: 50(0.917) + 54(0.842) + 58(0.772) = 45.9 + 45.5 + 44.8 = $136.2m.
- +1PV of the continuing value: 700 × 0.772 = $540.4m (discount the CV by the year-3 factor, the same as the last explicit cash flow).
- +1(b) Enterprise value: EV = 136.2 + 540.4 = $676.6m. Note the CV is ~80% of EV — normal, and why the terminal assumption is the most leveraged input.
- +1(c) Bridge and per share: equity = EV − net debt = 676.6 − 200 = $476.6m; value per share = 476.6 ÷ 100 = $4.77.
Key terms
- Free cash flow to the firm (FCFF)
- The after-tax cash an operating business generates for all providers of capital, debt and equity alike. It starts from NOPLAT, adds back non-cash charges and subtracts reinvestment in invested capital, and crucially excludes interest (financing is captured in the WACC). FCFF is discounted at the WACC.
- Free cash flow to equity (FCFE)
- The residual cash available to equity holders only, after debt is serviced. It is discounted at the cost of equity to give equity value directly, with no bridge. The course uses enterprise DCF (FCFF at WACC) as the default and reserves FCFE for financial institutions.
- Terminal / continuing value (CV)
- The value of operations after the explicit forecast ends, collapsed into one number dated at the horizon. Estimated by convergence (NOPLATₜ₊₁/WACC, the course default), the Gordon/key-value-driver formula, or an exit multiple. It is usually the majority of enterprise value, so its assumptions dominate the answer.
- Enterprise value (EV)
- In DCF, the value of operations plus the value of non-operating assets — what the whole business is worth to all investors. The EV→equity bridge subtracts net debt, minority interest and other non-equity claims to reach equity value.
- ROIC vs WACC
- Return on invested capital versus the weighted-average cost of capital — the value-creation test. Value is created only when ROIC > WACC; when ROIC < WACC, growing faster destroys value. This single comparison threads through every week of the course.
DCF Valuation Foundations FAQ
Why discount FCFF at the WACC rather than the cost of equity?
Because the numerator and denominator must refer to the same claimholders. FCFF is the cash to all investors (debt and equity), so it is discounted at the blended return all investors require — the WACC. FCFE, the cash to equity only, is discounted at the cost of equity. Crossing them (FCFF at the cost of equity, or FCFE at the WACC) is the single most common and most costly DCF mistake.
Why is the terminal value usually the biggest part of the answer?
A firm has a potentially unlimited life, but you can only forecast a handful of years explicitly. Everything after the horizon collapses into the continuing value, which often makes up 60–80% of enterprise value. That is why a careless growth or WACC assumption in the terminal value swings the whole valuation — treat it with respect and always sensitivity-test g and WACC.
Which terminal-value method should I use?
Use convergence (CV = NOPLATₜ₊₁ / WACC) as the default — it assumes competition drives the return on new capital down to the cost of capital, so growth adds nothing beyond the horizon. Use the Gordon / key-value-driver form only when you can justify continued excess returns (RONIC > WACC). An exit multiple is a quick cross-check but is only as good as the comparable. State which you chose and why, and cross-check the methods against each other.
What is the difference between intrinsic, book and market value?
Intrinsic (fair) value is the present value of future cash flows — what a DCF estimates. Book value is the accounting balance-sheet number, at historical cost. Market value is the observable traded price, which depends on market efficiency. They are three different numbers measuring three different things; the gap between your intrinsic value and the market price is the investment thesis.
Exam move
Learn the one-picture DCF first and learn it cold: forecast FCFF, discount each year and the terminal value at the WACC, sum to enterprise value, then bridge EV → equity → per share. Drill the five-beat answer shape the markers reward — set up assumptions, build/compute, bridge to per share, sanity-check (ROIC > WACC? CV plausible?), recommend. Keep three traps front of mind: discount-rate mismatch (FCFF at WACC, FCFE at the cost of equity, never crossed), nominal-vs-real consistency (a nominal cash flow needs a nominal WACC and growth), and double-counting (interest lives in the WACC, not in FCFF; non-operating items enter the bridge, not NOPLAT). Because the exam is applied and closed-book, the safest marks come from a clean, consistent build you can reproduce on fresh numbers.
