Complete DCF Walkthrough: From Assumptions to Share Price#

You've learned each component of a DCF. Now it's time to put everything together and value a company from scratch. We'll walk through the entire process using NexGen Software, a fictional mid-sized enterprise software company.

Step 1: Understand the Company#

Before building spreadsheets, understand the business:

NexGen Software Profile#

Recent Financials#

Step 2: Build Revenue Projections#

Using the approaches from our forecasting lesson:

Historical Growth#

• 3-year CAGR: 18%
• Last year: 15%
• Trend: Decelerating as company matures

Market Context#

• Enterprise software market growing ~10% annually
• NexGen gaining share but facing more competition
• TAM for mid-market ERP: ~$15B

Revenue Projection#

5-year CAGR: 9.5% (reasonable for maturing software company)

Step 3: Project Margins and Costs#

Operating Margin Build#

As NexGen scales, we expect margin expansion from operating leverage:

Key Assumptions:

• Gross margin improves slightly (scale in hosting, subscription mix)
• R&D declines as % of revenue (existing products generate more revenue)
• S&M efficiency improves (brand recognition, customer referrals)
• G&A shows operating leverage (fixed corporate costs)

Step 4: Calculate Free Cash Flow#

FCFF Calculation#

Assumptions:

• Tax rate: 25%
• Depreciation: ~3% of revenue (software is asset-light)
• CapEx: 5% of revenue (includes capitalized software development)
• Working capital: 10% of revenue (change = 10% × revenue growth)

Step 5: Calculate WACC#

Cost of Equity (using CAPM)#

Cost of Equity = Risk-Free Rate + Beta × Equity Risk Premium

Cost of Equity = 4.5% + 1.1 × 5.5% = 10.55%

Cost of Debt#

Cost of Debt (after-tax) = Interest Rate × (1 - Tax Rate)
Cost of Debt = 6% × (1 - 0.25) = 4.5%

WACC Calculation#

We'll use 10% for round numbers (within reasonable range).

Step 6: Calculate Terminal Value#

Using the Perpetuity Growth Method:

Terminal Value = Final Year FCF × (1 + g) / (WACC - g)

Terminal Value = $280M × 1.03 / (0.10 - 0.03)
Terminal Value = $288M / 0.07
Terminal Value = $4,118M

Step 7: Discount Cash Flows to Present Value#

Now we bring everything back to today's value:

Sum of Present Values:

• PV of Explicit FCFs (2025-2029): $722M
• PV of Terminal Value: $2,557M
• Enterprise Value: $3,279M

What This Tells Us#

Terminal value represents 78% of total Enterprise Value ($2,557M / $3,279M). This is typical for DCF models—most value comes from the "forever" cash flows after the explicit forecast period.

Step 8: Bridge to Equity Value#

Enterprise Value represents the value to all capital providers. To get equity value (what shareholders own):

Equity Value = Enterprise Value - Net Debt + Non-Operating Assets

Step 9: Calculate Per-Share Value#

Intrinsic Value Per Share = Equity Value / Shares Outstanding
Intrinsic Value = $3,079M / 100M shares = $30.79 per share

Step 10: Sensitivity Analysis#

But our assumptions might be wrong. Let's test different scenarios:

WACC vs. Terminal Growth Rate#

Revenue Growth Sensitivity#

Operating Margin Sensitivity#

Interpreting Our Results#

The Range of Values#

From sensitivity analysis, reasonable intrinsic value ranges from $24 to $57 per share:

• Bear case: Lower growth, lower margins, higher WACC → $24
• Base case: Our primary assumptions → $31
• Bull case: Higher growth, margin expansion, lower WACC → $42-57

Investment Decision Framework#

At $45, NexGen trades above even our bull case base ($42) unless you believe in the most optimistic scenario (4% perpetual growth, 9% WACC). This suggests limited margin of safety.

Common DCF Mistakes to Avoid#

1. Terminal Value Dominance#

If terminal value is >90% of enterprise value, your explicit forecasts don't matter much. Either extend the forecast period or question your terminal assumptions.

2. Inconsistent Assumptions#

If you project 3% terminal growth but assume the company reaches 40% market share, those assumptions conflict. Growth slows when you dominate your market.

3. Ignoring Competition#

Our margin expansion assumes NexGen can reach 33% operating margins. But if competitors cut prices, margins could compress. Always consider competitive scenarios.

4. False Precision#

We calculated $30.79. But given the uncertainty, saying "$28-34 range" is more honest than implying three-decimal precision.

5. Forgetting Non-Operating Items#

Some companies have significant non-operating assets (investments, real estate, cash). These add to equity value beyond the DCF of operating cash flows.