DCF Valuation: WACC, Terminal Value, and the Assumptions That Actually Move It

A discounted cash flow model answers one question: what is a company's future cash flow worth today? Everything else (the forecast, the discount rate, the terminal value) exists in service of that single conversion. Understanding which pieces actually move the answer, and by how much, is what separates someone who can build a DCF from someone who can defend one.

Unlevered free cash flow: the numerator

UFCF = EBIT × (1 − Tax Rate) + D&A − Capex − Increase in NWC

Starting from EBIT rather than EBITDA matters: it lets you tax-effect operating income the way it would be taxed with no debt at all, which is what makes this "unlevered": capital-structure-neutral. That's also why UFCF gets discounted at WACC (a blended cost across all capital providers) rather than just the cost of equity: it's cash available to everyone who financed the business, before any financing decision has been made.

The discount rate

WACC = (E/V × Cost of Equity) + (D/V × Cost of Debt × (1 − Tax Rate))

Cost of Equity typically comes from CAPM (Risk-Free Rate + Beta × Equity Risk Premium); Cost of Debt is the company's real current borrowing rate, tax-effected because interest is deductible. Use market values of debt and equity for the weights, not book values. Book equity routinely understates what the market actually thinks a company is worth, and using it skews the blend toward whichever side happens to look cheaper on paper.

WACC is also the single most sensitive input in the entire model. Because it compounds (every future year's cash flow gets discounted by (1 + WACC)^n), a one-point change in WACC can move enterprise value by double digits on a percentage basis, especially for a company with most of its value sitting far out in the terminal period. This is exactly why a real DCF is never presented as one number: it's presented as a sensitivity table across a WACC range and a growth or exit-multiple range, because a single point estimate implies false precision the underlying assumptions don't support.

Terminal value: the majority of the whole valuation

Explicit forecasts rarely run more than 5–10 years, but a company doesn't stop existing after that. Terminal value captures everything beyond the forecast window, and for most companies it's the majority of total enterprise value, often 60–80%. Two standard methods:

Gordon Growth (Perpetuity Growth):

TV = Final Year UFCF × (1 + g) ÷ (WACC − g)

Assumes cash flow grows at a constant rate g forever. g needs to be conservative (roughly long-run GDP/inflation, 2–3%) because no company can structurally outgrow the entire economy indefinitely.

Exit Multiple:

TV = Final Year EBITDA × Exit EV/EBITDA Multiple

Uses a market-observed multiple instead of an assumed growth rate, easier to sanity-check, and the more commonly used method in practice.

The best practice, and a favorite interview trap: calculate both, and cross-check them against each other. A Gordon Growth terminal value that implies an absurd exit multiple (or vice versa) is a sign one of the two assumptions is unrealistic, even if each looks individually reasonable in isolation.

Discounting it back, and the mid-year refinement

PV of Explicit UFCF = Σ [ UFCF_t ÷ (1 + WACC)^t ]
PV of Terminal Value = TV ÷ (1 + WACC)^n
Enterprise Value = PV of Explicit UFCF + PV of Terminal Value

A refinement worth knowing even if you don't always use it: the mid-year convention. Standard discounting assumes every year's cash flow lands on the very last day of the period, but a real company generates cash roughly evenly throughout the year, so discounting from the period's midpoint (0.5, 1.5, 2.5 years) rather than its end (1, 2, 3 years) is a more accurate reflection of when that cash actually arrives, and it modestly increases the present value of near-term cash flows. It's a small effect, but it signals precision, and it's a common enough refinement that not knowing it exists is a noticeable gap.

From Enterprise Value to a share price

Equity Value = Enterprise Value − Net Debt
Implied Share Price = Equity Value ÷ Diluted Shares Outstanding

This is also where a DCF earns its place in a football field alongside trading comps and precedent transactions: it's the one methodology that's entirely intrinsic, derived purely from the company's own projected cash flows rather than from what the market is currently paying for comparable companies. That independence is exactly why it's valuable, and exactly why it can also diverge sharply from what comps imply: a gap worth investigating, not smoothing over, whenever it shows up.