intrinsic-valuation-dcf

What this skill does

# Intrinsic Valuation (DCF)

## Table of Contents
- [Example](#example)
- [Workflow](#workflow)
- [Common Patterns](#common-patterns)
- [Guardrails](#guardrails)
- [Quick Reference](#quick-reference)

## Example

**Scenario**: Two-stage FCFF model for a mature growth company

**Inputs**:
- Base year EBIT: $500M, Tax rate: 25%, CapEx: $200M, Depreciation: $150M, WC change: $20M
- High-growth period: 5 years, revenue growth 12%, reinvestment rate 50%, WACC 9%
- Stable period: perpetual growth 3%, reinvestment rate 30%, WACC 8.5%

**Step-by-step**:

1. Base year after-tax operating income: $500M x (1 - 0.25) = $375M
2. Base year FCFF: $375M - ($200M - $150M) - $20M = $305M

3. Year-by-year projections (high-growth, 12% growth, 50% reinvestment):

| Year | After-tax EBIT | Reinvestment | FCFF    | PV Factor (9%) | PV of FCFF |
|------|---------------|-------------|---------|----------------|------------|
| 1    | $420.0M       | $210.0M     | $210.0M | 0.9174         | $192.7M    |
| 2    | $470.4M       | $235.2M     | $235.2M | 0.8417         | $198.0M    |
| 3    | $526.8M       | $263.4M     | $263.4M | 0.7722         | $203.4M    |
| 4    | $590.1M       | $295.0M     | $295.0M | 0.7084         | $208.9M    |
| 5    | $660.9M       | $330.4M     | $330.4M | 0.6499         | $214.8M    |

4. Terminal value (end of year 5):
   - Stable FCFF = $660.9M x (1.03) x (1 - 0.30) = $476.5M
   - Terminal value = $476.5M / (0.085 - 0.03) = $8,663M
   - PV of terminal value = $8,663M x 0.6499 = $5,631M

5. Firm value = $1,017.8M + $5,631M = $6,649M

6. Equity bridge:
   - Firm value: $6,649M
   - Minus debt: -$2,000M
   - Plus cash: +$500M
   - Minus employee options: -$200M
   - Equity value: $4,949M
   - Per share (100M shares): **$49.49**

7. Sensitivity grid (per-share value):

| WACC \ Growth | 2.0%  | 2.5%  | 3.0%  | 3.5%  | 4.0%  |
|---------------|-------|-------|-------|-------|-------|
| 7.5%          | $62   | $68   | $76   | $86   | $99   |
| 8.0%          | $53   | $57   | $62   | $69   | $78   |
| 8.5%          | $45   | $48   | $52   | $57   | $63   |
| 9.0%          | $39   | $41   | $44   | $48   | $52   |
| 9.5%          | $34   | $36   | $38   | $41   | $44   |

## Workflow

Copy this checklist and track your progress:

```
DCF Valuation Progress:
- [ ] Step 1: Select DCF model variant
- [ ] Step 2: Establish base year cash flows
- [ ] Step 3: Estimate growth rate and high-growth period length
- [ ] Step 4: Project year-by-year cash flows
- [ ] Step 5: Compute terminal value
- [ ] Step 6: Discount, bridge to equity, compute per-share value
- [ ] Step 7: Build sensitivity analysis
```

**Step 1: Select DCF model variant**

Choose the model that matches the company and context. See [resources/methodology.md](resources/methodology.md#model-selection-decision-tree) for the full decision tree.

Quick selection guide:
- **FCFF**: Default for most companies. Values the entire firm, discounts at WACC, subtracts debt for equity. Use when capital structure is expected to change or when the company has significant debt.
- **FCFE**: Values equity directly, discounts at cost of equity. Use when capital structure is stable and debt ratio is predictable.
- **DDM**: Values equity via dividends, discounts at cost of equity. Use for mature, stable dividend-paying companies (utilities, REITs, mature banks).

**Step 2: Establish base year cash flows**

Start from cleaned financials (ideally from financial-statement-analyzer output). See [resources/template.md](resources/template.md#base-year-inputs) for the base year input template.

For FCFF:
- After-tax operating income = EBIT x (1 - tax rate)
- FCFF = After-tax EBIT - (CapEx - Depreciation) - Change in non-cash working capital

For FCFE:
- FCFE = Net Income - (CapEx - Depreciation) - Change in WC + (New debt issued - Debt repaid)

For DDM:
- Current dividends per share, payout ratio, earnings per share

**Step 3: Estimate growth rate and high-growth period length**

See [resources/methodology.md](resources/methodology.md#growth-estimation) for growth estimation methods.

Three approaches to estimating growth:
- **Fundamental**: g = Reinvestment rate x Return on capital (for FCFF) or g = Retention ratio x ROE (for FCFE/DDM)
- **Historical**: Extrapolate recent growth with judgment about sustainability
- **Analyst consensus**: Use as cross-check, not primary source

High-growth period length depends on competitive advantage magnitude and sustainability (typically 5-10 years).

**Step 4: Project year-by-year cash flows**

Build the projection table for each year of the high-growth period. See [resources/template.md](resources/template.md#year-by-year-projection-table) for the projection template.

For each year, compute:
- Revenue (or operating income) based on growth rate
- Reinvestment (based on reinvestment rate or sales-to-capital ratio)
- Free cash flow = Income after tax - Reinvestment
- Present value factor = 1 / (1 + discount rate)^year
- Present value of cash flow

**Step 5: Compute terminal value**

See [resources/methodology.md](resources/methodology.md#terminal-value) for terminal value approaches and constraints.

Growing perpetuity (preferred):
- Terminal value = CF in year n+1 / (discount rate - stable growth rate)
- Stable growth rate should not exceed the risk-free rate or nominal GDP growth
- Reinvestment rate in stable period: g / ROC (so growth is consistent with reinvestment)
- Cost of capital should converge toward mature company levels

Exit multiple cross-check (secondary):
- Apply industry EV/EBITDA or PE multiple to terminal year financials
- Compare to perpetuity-based terminal value for reasonableness

**Step 6: Discount, bridge to equity, compute per-share value**

See [resources/template.md](resources/template.md#equity-bridge) for the equity bridge template.

1. Sum PV of high-growth cash flows + PV of terminal value = Operating asset value
2. Add: Value of cash and non-operating assets
3. Subtract: Market value of debt (all debt included in WACC calculation)
4. Subtract: Value of employee stock options (use treasury stock method or Black-Scholes)
5. Subtract: Minority interests (at market value if available)
6. Divide by diluted share count = Per-share intrinsic value

**Step 7: Build sensitivity analysis**

See [resources/template.md](resources/template.md#sensitivity-grid) for the sensitivity grid template.

At minimum, vary:
- Stable growth rate (rows)
- Discount rate / WACC (columns)

Additional sensitivity dimensions to consider:
- Revenue growth rate in high-growth period
- Target operating margin
- Length of high-growth period
- Reinvestment rate

Validate using [resources/evaluators/rubric_intrinsic_valuation_dcf.json](resources/evaluators/rubric_intrinsic_valuation_dcf.json). **Minimum standard**: Average score of 3.5 or higher.

## Common Patterns

**Pattern 1: FCFF Two-Stage (Most Common)**
- **When**: Company with identifiable high-growth period followed by stable growth. Changing or uncertain capital structure. Most non-financial companies.
- **Structure**: Project FCFF for 5-10 years at above-normal growth, then terminal value at stable growth. Discount at WACC.
- **Equity bridge**: Firm value - Debt + Cash - Options = Equity value
- **Key risk**: Terminal value dominance. If terminal value exceeds 85% of total value, consider whether the high-growth period is too short or growth too low.

**Pattern 2: FCFE Two-Stage**
- **When**: Stable, predictable capital structure. Company manages to a target debt ratio. Financial services firms where FCFF is not meaningful.
- **Structure**: Project FCFE for high-growth period, then terminal value. Discount at cost of equity.
- **Equity bridge**: Not needed -- result is equity value directly. Subtract option value, divide by shares.
- **Key risk**: Debt ratio assumption. If actual debt policy deviates from assumption, value will be wrong.

**Pattern 3: Dividend Discount Model (DDM)**
- **When**: Mature, stable companies with lon