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Learn / IB

DCF and WACC

Turn forecasts into value with WACC, terminal value, sensitivities, and the DDM.

60 min6 checkpointsMastery —stub

Module roadmap

Mastery —
  1. 1lessonForecasts, WACC, and terminal value
  2. 2diagramDCF flow diagram
  3. 3diagramWACC build-up diagram
  4. 4diagramQuiz: build WACC
  5. 5concept labWhen a DCF does not fit: the DDM for banks
  6. 6drillDCF judgement drill

Work through in order

Checkpoints

learn → see → test → drill

  1. Checkpoint 1 · lesson

    Forecasts, WACC, and terminal value

    Valuation / DCF

    Prereq

    Review Accounting Foundations, Enterprise Value and Equity Value before this checkpoint.

    The idea

    A discounted cash flow values a business as the present value of the cash it will generate for all capital providers. It is an intrinsic method: it depends on your forecast and discount rate, not on what peers trade at.

    Five steps

    1. Forecast unlevered free cash flow for 5–10 years — long enough for the business to reach a steady state.
    2. Calculate WACC, the blended return required by equity and debt investors.
    3. Estimate terminal value for all years after the forecast.
    4. Discount the forecast cash flows and terminal value to today and sum them to enterprise value.
    5. Bridge to equity value and divide by diluted shares.

    Unlevered free cash flow

    UFCF = EBIT × (1 − tax rate) + D&A − capex − increase in net working capital

    It is "unlevered" because it is before interest, so it belongs to both debt and equity holders — which is why it is discounted at WACC. Levered free cash flow (after interest and debt repayments) belongs to equity only, is discounted at the cost of equity, and produces equity value directly.

    WACC

    WACC = E/V × cost of equity + D/V × pre-tax cost of debt × (1 − t)

    Cost of equity usually comes from CAPM: risk-free rate + levered beta × equity risk premium. Beta is taken from peers, unlevered to strip out their capital structures, then relevered at the target's structure. More debt raises the cost of equity (more financial risk) but can lower WACC at first because debt is cheaper and tax-deductible.

    Warren

    Warren

    WACC is an opportunity cost, not a negotiating position. Unlever the beta, then relever for the target structure — mixing levered and unlevered figures is the classic slip.
    Open concept lab →

  2. Checkpoint 2 · diagram

    DCF flow diagram

    Valuation / DCF
    DCF and WACC Flowcanvas

    Drawing diagram…

    Read the diagram in words

    Forecast revenue down to EBIT, tax it to NOPAT, then add back D&A and subtract capex and the increase in net working capital to get unlevered free cash flow. Discount each year's UFCF and a terminal value (Gordon growth or exit multiple) at WACC and sum them to enterprise value. Bridge to equity value by subtracting net debt, preferred stock and non-controlling interest and adding non-operating assets, then divide by diluted shares for an implied share price.

  3. Checkpoint 3 · diagram

    WACC build-up diagram

    Valuation / DCF
    WACC build-upcanvas

    Drawing diagram…

    Read the diagram in words

    Cost of equity comes from CAPM: the risk-free rate plus levered beta times the equity risk premium, where beta is unlevered from peers and relevered at the target capital structure. Cost of debt is the pre-tax yield times one minus the tax rate because interest is tax-deductible. WACC weights the two by market-value equity and debt proportions, and it is the rate used to discount unlevered free cash flow and terminal value.

  4. Checkpoint 4 · diagram quiz

    Quiz: build WACC

    Valuation / DCF
    Quiz: WACC build-upfill in · 0/4

    Risk-free rate 4%, levered beta 1.2, equity risk premium 5%, pre-tax cost of debt 6%, tax rate 25%, target debt / total capital 30%. Build WACC.

    Fill-in quiz. Cost of equity is 4% + 1.2 × 5% = 10.0%. After-tax cost of debt is 6% × (1 − 25%) = 4.5%. With 70% equity and 30% debt, WACC = 0.7 × 10.0% + 0.3 × 4.5% = 8.35%, the discount rate for unlevered free cash flow.× (1 − t)Risk-free 4%Levered beta 1.2Equity risk premium 5%Pre-tax cost of debt 6%, tax25%Cost of equity (CAPM)blank 1After-tax cost of debtblank 2Capital structure weightsblank 3WACCblank 4Discount rate for unleveredFCF
    1. Cost of equity (CAPM)
    2. After-tax cost of debt
    3. Capital structure weights
    4. WACC

  5. Checkpoint 5 · concept lab

    When a DCF does not fit: the DDM for banks

    Valuation / DCF

    Why banks break the normal DCF

    For an industrial company, debt is financing and interest sits below operating profit. For a bank, deposits and borrowings are the raw material: interest expense is a cost of goods sold. There is no meaningful EBITDA, capex or working capital, and regulators require the bank to hold a minimum level of equity capital. So we value the equity directly using a dividend discount model (DDM), discounting at the cost of equity, not WACC.

    Steps in a DDM

    1. Project the balance sheet — loans and deposits drive interest income and expense.
    2. Project net income — net interest income + fees − operating costs − loan loss provisions − taxes.
    3. Set the capital requirement — e.g. keep CET1 capital at 11% of risk-weighted assets. Growing the balance sheet requires retaining earnings.
    4. Dividends = net income − capital required to support growth. Excess capital above the target can be treated as distributable.
    5. Discount dividends and a terminal value at the cost of equity. Terminal value comes from Gordon growth on dividends or a P / E or price to tangible book multiple.
    6. The sum is equity value; divide by diluted shares. There is no EV bridge.

    Worked example: Gordon growth DDM

  6. Checkpoint 6 · drill

    DCF judgement drill

    Valuation / DCF

    Starts a module drill with 6 questions linked to this checkpoint. Answer out loud first, then compare.

Firm application

Apply this module

Warren
Focuses the RAG pack on Valuation / DCF.
Warren

Warren

WACC is an opportunity cost, not a negotiating position. Unlever the beta, then relever for the target structure — mixing levered and unlevered figures is the classic slip.
Terminal value, with numbers

Gordon growth: TV = UFCF in year n × (1 + g) ÷ (WACC − g).

Year-5 UFCF 100, WACC 10%, g 2%: TV = 102 ÷ 0.08 = 1,275. Discount factor for year 5 is 1 ÷ 1.10^5 = 0.621, so the PV of TV is about 792.

Exit multiple: TV = year-n EBITDA × multiple. With year-5 EBITDA of 150 at 8.0x, TV = 1,200. Cross-check the implied perpetual growth rate: g = (TV × WACC − UFCF) ÷ (TV + UFCF) = (120 − 100) ÷ 1,300 ≈ 1.5%, which is sensible. If the implied growth were 6%, the multiple would be too high.

Terminal value is often 60–80% of total EV, which is why sensitivity tables matter.

Sensitivities and judgement

  • A 1% change in the discount rate usually moves value more than a 1% change in revenue, because it compounds through every year and the terminal value.
  • Show WACC vs terminal growth (or exit multiple) tables, and revenue growth vs margin tables.
  • The mid-year convention assumes cash arrives mid-year, discounting year 1 by 0.5 periods instead of 1, which raises value slightly.

When not to use a DCF

When cash flows are unpredictable (early-stage companies), negative for a long time, or when debt is operating raw material, as with banks and insurers — use a dividend discount model or P / TBV there instead.

Interview answer template

"Project unlevered free cash flow for five to ten years, discount it at WACC, add the present value of a terminal value from either Gordon growth or an exit multiple, and that is enterprise value. Subtract net debt and other claims to get equity value and divide by diluted shares."

Next year's net income 120, return on equity (ROE) 12%, so beginning book equity is 1,000. The bank retains one third of earnings to fund growth, so sustainable growth g = ROE × retention = 12% × 1/3 = 4%. Dividends next year = 120 × 2/3 = 80. Cost of equity 10%.

  • Equity value = 80 ÷ (10% − 4%) = 1,333
  • Implied price / book = 1,333 ÷ 1,000 = 1.33x

This matches the justified P / B formula: (ROE − g) ÷ (Ke − g) = (12% − 4%) ÷ (10% − 4%) = 1.33x. The intuition interviewers want: a bank trades above book only if its ROE exceeds its cost of equity. At ROE of 10% the same bank would be worth exactly book value.

What else differs for financial institutions

  • Multiples: P / E, P / book and P / tangible book instead of EV / EBITDA.
  • Key metrics: net interest margin, efficiency ratio, CET1 ratio, non-performing loans, ROE and ROTE.
  • Insurers: DDM or embedded value; float and reserves play the role of deposits.

Interview traps

  1. Discounting dividends at WACC — dividends belong to equity, so use the cost of equity.
  2. Adding debt or subtracting cash to get to equity value — the DDM already produces equity value.
  3. Forgetting the capital constraint: a bank cannot pay out all its earnings if it wants to grow its loan book.

One-line answer

"For a bank I'd use a dividend discount model: project net income, retain enough to meet capital requirements, treat the rest as dividends, and discount dividends plus a terminal value at the cost of equity to get equity value directly."

Dividend discount model for bankscanvas

Drawing diagram…

Read the diagram in words

A dividend discount model values a bank's equity directly. Project net income, retain enough earnings to keep regulatory capital (for example CET1) at the target ratio as the balance sheet grows, and treat the rest as dividends. Discount the dividends and a terminal value, from Gordon growth on the next dividend or a price to tangible book or P/E multiple, at the cost of equity. The sum is equity value, with no enterprise value bridge, because debt and deposits are operating raw material for a bank. Divide by diluted shares for value per share.

Open concept lab →