How to Derive and Assemble Key Inputs for Discounted Cash Flow (DCF) Valuation!

In the previous article, we discussed the fundamentals of Discounted Cash Flow (DCF) valuation, its use cases, and the key inputs involved such as FCFF/FCFE, cost of capital, terminal value, and growth assumptions. If you haven’t read it yet, here’s the link: Understanding Discounted Cash Flow Valuation (DCF): A Comprehensive Guide! Now that we understand what DCF is and the role of its key components, we’ll move forward to explore how to derive these inputs and take a more practical, hands-on approach to applying them.

Breaking Down DCF Inputs: A Practical Guide to Deriving Key Assumptions

Discounted Cash Flow (DCF) valuation is only as reliable as the assumptions used to derive its inputs. The accuracy of a DCF hinges on how well we estimate and apply key variables like projected cash flows (FCFE/FCFF), discount rates (cost of equity or WACC), and growth rates. Here’s how each of these inputs can be derived with a structured approach.

Free Cash Flows: FCFF vs. FCFE

Free Cash Flow to Equity (FCFE) reflects cash available to shareholders after meeting debt obligations. It is calculated as:
FCFE = Net Income + Depreciation & Amortization – Change in Net Working Capital – CapEx + Net Borrowing

Free Cash Flow to Firm (FCFF) measures the cash flow available to both debt and equity holders. It can be derived using:
FCFF = EBIT × (1 – tax rate) + Depreciation – CapEx – Change in Working Capital

Key components like net income and depreciation are obtained from the income statement. CapEx is typically the increase in fixed assets adjusted for depreciation. Net borrowing is the difference between new debt raised and repayments.

Working capital adjustments are important too:

• Increase in Current Assets means cash is tied up → subtract it.
• Decrease in Current Assets implies cash inflow → add it.
• Increase in Current Liabilities means delayed payments to creditors → add it.
• Decrease in Liabilities indicates cash outflow → subtract it.

Estimating Growth Rates

Growth projections should be based on:

• Historical financial trends
• Peer and sector growth
• Company strategy and macroeconomic environment

Terminal growth (used beyond the forecast period) should be conservative, often tied to inflation or GDP growth around 5–6 per cent for stable businesses.

Cost of Equity (Ke) via CAPM

The Capital Asset Pricing Model helps estimate the return equity investors expect:
Ke = RFR + Beta × ERP

• RFR (Risk-Free Rate): Typically, the 10-year government bond yield.
• Beta: A stock’s sensitivity to market movements, usually derived by regression or can be found with data providers.
• ERP (Equity Risk Premium): The additional return over risk-free rate expected from equities.

WACC for Discounting FCFF

When using FCFF, discount cash flows using the Weighted Average Cost of Capital:
WACC = (E/V) × Ke + (D/V) × Kd × (1 – Tax Rate)
Where E/V and D/V represent market-based capital structure, and Kd is the after-tax cost of debt.

Putting It All Together

After projecting FCFF or FCFE over a 5-10 year horizon, calculate the terminal value using a perpetuity growth method. FCFE is discounted using Ke, while FCFF is discounted using WACC. The sum of present values gives you the intrinsic value. A well-constructed DCF requires sound assumptions, clear documentation, and sensitivity analysis to handle uncertainties.

What’s Next?

Now that we've covered how to derive key inputs for DCF valuation, like FCFF/FCFE, cost of capital, growth rates, and terminal value you should have a solid grasp of what DCF entails and how it works. In the next article, we’ll explore some of the less commonly used valuation methods. Stay tuned, and feel free to check out our previous articles in the meantime.