Learning objectives
By the end you can:
- Define and compute FCFF three ways from real statements: from EBIT (
FCFF = EBIT(1−t) + D&A − capex − ΔWC), from net income, and from CFO. Reconcile all three to the same number, and handle the classification traps (interest in CFO vs CFF under US GAAP / IFRS / Ind AS, stock-based compensation, leases, acquisitions) without double-counting. - Define and compute FCFE (
FCFE = FCFF − interest(1−t) + net borrowing), explain what net borrowing is doing there, and state when FCFE is the better tool and when it is a trap. - Apply the matching rule without exception: FCFF ↔ WACC ↔ enterprise value; FCFE ↔ cost of equity ↔ equity value. Quantify, in percent of value, what each of the two classic mismatches does to a valuation.
- Build a revenue forecast three ways (market size × share, capacity × utilization × price, units × price), choose the right architecture for the business, and discipline every growth number against base rates and the law of large numbers.
- Forecast margins from drivers: separate gross-margin economics from operating leverage, anchor the path to sector gravity, and attach a mechanism to every point of assumed improvement.
- Forecast reinvestment both ways: explicit capex + D&A + working capital, and Damodaran's sales-to-capital shortcut (
reinvestment = Δrevenue ÷ sales-to-capital). Reconcile the two. - Derive and police the growth-quality tie
g = reinvestment rate × ROIC: given any two of growth, reinvestment, and ROIC, solve for the third; audit any forecast (yours or a broker's) for the internal inconsistency that is the single most common amateur DCF error; and run the implied-ROIC check on every model you build. - Construct base, bull, and bear cases as coherent stories, scenarios in which every driver moves together for a stated economic reason, and explain why "±10% on revenue" is not a scenario.
Prerequisites & connections
Builds on. M3.03 directly. The two discount rates built there (cement leader ≈ 11.0% INR WACC / 11.4% cost of equity; US home-improvement retailer ≈ 7.8% USD WACC / 8.4% cost of equity, on an illustrative mid-2026 stack: US Rf 4.2%, clean INR Rf 4.5%, mature ERP 4.3%, India CRP 2.8%, re-pull live before real use) are consumed here as finished inputs, and the currency rule (INR cash flows ↔ INR rates) now gets applied to the numerator. M3.01: PV mechanics and the Fisher real↔nominal logic that makes an Indian revenue forecast carry Indian inflation. M2.03–M2.05: ROIC, NOPAT, invested capital, non-cash working capital, and cash-conversion analysis, all of it run forward in time here instead of backward. M2.06–M2.08: base-year cleaning (one-offs, aggressive revenue, capitalization games), because you cannot forecast from a polluted base. M1.05/M1.08: D&A mechanics, lease accounting across the three standards, and the cash-flow-statement classification differences that decide how you extract FCFF from a filing.
Feeds forward. M3.05 completes this DCF: terminal value (where most of the value computed here will turn out to live), sensitivity, scenario weighting, and the reverse DCF. M3.06: every multiple is a compressed version of this module — P/E and EV/EBITDA are DCFs with the forecasting hidden. M3.07: g = RR × ROIC becomes the key-value-driver formula and the capital-allocation report card. M3.08–M3.09: the model stack automates what you do by hand here, and the working agreement stands: by hand first. Phase 8: the 2–3 day deep dive's Day-2 model is exactly this module executed at speed.
The one-sentence version of this module. A DCF is a discipline that forces your story about a company through arithmetic that refuses to let the story cheat. It is not a machine that tells you what a company is worth. Free cash flow is what the story pays out, and the growth-reinvestment-ROIC tie is where cheating gets caught.
4.1 What a DCF actually is: a structured argument, not an oracle
Strip every valuation method on earth to its chassis and one idea remains: the value of any asset is the present value of the cash flows you expect it to deliver, discounted at a rate that reflects their risk. A bond is the clean case: promised coupons, contractual dates, observable rate. A business is the hard case: the cash flows are not promised, their size depends on competition and management and macro weather, and they stretch beyond any horizon you can see. The DCF's answer: