DCF valuation

Definition

Discounted cash flow values a business as the present value of its expected future free cash flows — the theoretically correct answer (value IS discounted cash, Miller-Modigliani’s framework formalizes it) with a practically treacherous implementation: small changes in growth and discount assumptions swing the output enormously, and most of the value typically sits in a terminal-value guess. The platform uses DCF as a DISCIPLINE (which assumptions does today’s price imply?) more than as a target generator.

How it works / structure

• Machinery: project free cash flows (revenue path × margin path − reinvestment) over an explicit horizon; terminal value beyond it (perpetuity growth or exit multiple); discount at a cost of capital; subtract net debt for equity value.
• Sensitivity structure (the honest core): value is hypersensitive to the discount-rate-minus-growth spread in the terminal term — a 1% change in either commonly moves fair value 20-30%; terminal value is regularly 60-80% of the total — the “forecast” is mostly the far assumptions.
• REVERSE DCF (engine-preferred form): fix the price, solve for the implied growth/margin path, grade its plausibility against base rates — converts an assumption contest into a falsifiable claim about what must happen.
• Rate linkage: the discount rate imports the rate regime (regime-rate-environments) — long-duration cash-flow profiles (high-growth) reprice hardest on rate moves, mechanically.

When it applies

Long-horizon fundamental theses (the implied-expectations frame); cross-checking multiples (fa-multiples-comparables — a multiple IS a compressed DCF with hidden assumptions); capital-allocation grading (does reinvestment clear the hurdle — fa-capital-allocation); understanding valuation’s rate sensitivity as arithmetic rather than narrative.

Risk profile & failure modes

• Precision theater: five-decimal outputs from one- significant-figure assumptions; the platform quotes DCF outputs as ranges over assumption grids, never points.
• Terminal-value laundering: optimistic theses hide in the perpetuity term where scrutiny is weakest — the reverse form drags it into the light.
• Discount-rate shopping: choosing the rate that produces the desired value inverts the exercise; rates are pinned to a stated method before the model runs.
• Forecast base-rate neglect: implied 20%-for-a-decade growth paths have measured historical base rates (low); plausibility grading against them is the discipline.

Evidence & limits

The valuation identity is Miller-Modigliani theory; the implementation canon is the practitioner literature (Koller et al). Evidence on DCF’s predictive power is indirect — value- factor evidence (strategy-factor-investing) shows cheap- vs-fundamentals portfolios carried premia in long samples; single-name DCF accuracy is undocumented and the platform makes no accuracy claim — the tool’s value is assumption honesty.

Falsifiable-thesis examples

Illustrations only, not signals:

• “X’s current price implies revenue CAGR above 15% for 8 years (reverse-DCF read); actual growth will fall below that path within two years” — falsified by the revenue record.
• “If the 10-year yield rises 100bp, X (long-duration cash flows) will underperform the equal-weight sector (duration thesis)” — falsified by the conditional pair.

Cross-references

• The compressed form: fa-multiples-comparables
• Inputs: fa-financial-statements, fa-guidance-estimates (the near path), fa-capital-allocation (reinvestment quality)
• The rate import: regime-rate-environments
• Systematic cousin: strategy-factor-investing (value)