How does business valuation work?

A DCF model converts assumptions about future cash flows into a present calculated value. That value always depends on the assumptions.

Try the valuation lab →

1. Separate facts from assumptions

Company profiles show historical financial data and calculated ratios. The separate valuation lab uses entirely fictional businesses. Its three presets are teaching examples, not industry forecasts or representations of listed issuers.

2. Project revenue and operating income

Revenue follows the previous year's revenue and the growth assumption. Growth changes linearly from its starting rate in year 1 to the terminal rate in year 10; it may rise or fall. Operating margin moves linearly from its initial level in year 1 to its target in year 5, then remains constant.

Revenueₜ = Revenueₜ₋₁ × (1 + Growthₜ)
EBITₜ = Revenueₜ × Operating marginₜ

3. Account for taxes and reinvestment

The simplified model taxes positive operating income at your tax rate. It assumes neither immediate tax refunds nor loss carryforwards for losses. Incremental revenue needs incremental capital. The sales-to-capital ratio tells you how much additional revenue one unit of additional investment supports.

NOPAT = EBIT − max(EBIT, 0) × Tax rate
Reinvestment = max(Revenueₜ − Revenueₜ₋₁, 0) / Sales-to-capital ratio
FCFF = NOPAT − Reinvestment

No capital is released when revenue shrinks. Depreciation and investment are combined into net reinvestment in this learning model. Operating cash flow minus capex from a filing is not identical to this FCFF.

4. Understand the cost of capital

Set WACC directly or derive it in the optional section from the cost of equity and debt. CAPM is a widely used model whose results depend on its assumptions.

Cost of equity = Risk-free rate + Beta × Equity risk premium
WACC = Equity weight × Cost of equity + Debt weight × Cost of debt × (1 − Tax rate)

Weights theoretically refer to market values. In the lab they are also user assumptions. WACC stays constant throughout the projection.

5. Discount cash flows and calculate terminal value

Present value of FCFFₜ = FCFFₜ / (1 + WACC)ᵗ

After year 10, the model assumes a steady state with a constant target margin, terminal growth and your chosen return on incremental invested capital (ROIC).

FCFF₁₁ = NOPAT₁₁ × (1 − Terminal growth / ROIC)
Terminal value at year 10 = FCFF₁₁ / (WACC − Terminal growth)

WACC must exceed terminal growth and this learning model also requires ROIC to exceed terminal growth and a nonnegative target margin. These constraints keep the simplified terminal calculation within its intended teaching range; they are not general economic laws. A computable result still does not establish economic plausibility.

6. Distinguish enterprise and equity value

Enterprise value = Sum of present values for years 1–10 + Present value of terminal value
Calculated equity value = Enterprise value + Cash − Debt

This simplified bridge excludes minority interests, preferred shares and other claims. A negative calculated equity value indicates a modelled funding gap, not a negative stock price. The lab calculates no share prices or buy/sell decisions.

7. Challenge the result

The sensitivity table shows how WACC and terminal growth interact. A high terminal-value share means the distant future dominates the result. Growth adds value only if the investment required earns sufficient returns. Explore margins and capital intensity as well.