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Module 9: Absolute Valuation - The Discounted Cash Flow (DCF) Model

We have analyzed the business, predicted its survival, and calculated its Free Cash Flow. Now, we calculate its absolute Intrinsic Value. The Discounted Cash Flow (DCF) model is the undisputed gold standard of Wall Street valuation.

1. The Core Philosophy

A company is worth exactly the Present Value of all the cash it will ever generate from today until the end of time, discounted back to today's value based on the riskiness of those cash flows.

2. The Weighted Average Cost of Capital (WACC)

Future cash is inherently uncertain. We must discount it. The WACC blends the cost of the company's Equity (the return shareholders demand) with the cost of its Debt (the interest rate bondholders demand), weighted by their respective proportions on the balance sheet.

  • A stable utility company (low risk) uses a low WACC (e.g., 6%).
  • A volatile biotech startup (high risk) requires a massive WACC (e.g., 15%), which mathematically crushes the present value of its future cash flows.

3. The Terminal Value (TV)

We cannot project year-by-year cash flows for 100 years. We project explicitly for 5 to 10 years, and then calculate a Terminal Value to represent the firm's worth from Year 11 into infinity. We use the Gordon Growth Model:

Terminal Value =

(Note: The Terminal Growth Rate can never exceed long-term US GDP growth, typically 2-3%, as a company cannot outgrow the economy forever).

Self-Reflection & Assessment

  1. Why must the Terminal Growth Rate in a DCF model mathematically never exceed the long-term growth rate of US GDP?
  2. How does an increase in a company's perceived risk (resulting in a higher WACC) impact its current intrinsic valuation?