What is the correct sequence for a DCF valuation?

What is the correct sequence for a DCF valuation?

• A. Forecast dividends and stock buybacks, discount to get equity value.
• B. Forecast unlevered free cash flows for the forecast horizon, discount at the cost of equity to determine enterprise value.
• C. Forecast unlevered free cash flows for the forecast horizon, discount at WACC to determine enterprise value, subtract net debt to derive equity value, and divide by shares if needed.
• D. Forecast net income, discount at WACC, and value equity directly.

Answer: (C)

The approach values the firm by forecasting cash flows available to all capital providers and discounting them at the overall cost of capital, then separating out debt to get equity value and, if needed, value per share. Start with unlevered free cash flows for the forecast horizon because these reflect the firm’s cash generation before any financing decisions. Discount these unlevered cash flows at the weighted average cost of capital to obtain enterprise value, which represents the value of the business independent of its capital structure. Subtract net debt (debt minus cash) to arrive at equity value, then divide by shares outstanding to get value per share if needed. This sequence is correct because it treats the enterprise as a whole, uses the appropriate discount rate for cash flows that aren’t tied to a specific financing mix, and then translates enterprise value into equity value and per-share value. The other options mix in dividends or net income, or apply the wrong discount rate, which does not align with the standard DCF framework.

The approach values the firm by forecasting cash flows available to all capital providers and discounting them at the overall cost of capital, then separating out debt to get equity value and, if needed, value per share. Start with unlevered free cash flows for the forecast horizon because these reflect the firm’s cash generation before any financing decisions. Discount these unlevered cash flows at the weighted average cost of capital to obtain enterprise value, which represents the value of the business independent of its capital structure. Subtract net debt (debt minus cash) to arrive at equity value, then divide by shares outstanding to get value per share if needed. This sequence is correct because it treats the enterprise as a whole, uses the appropriate discount rate for cash flows that aren’t tied to a specific financing mix, and then translates enterprise value into equity value and per-share value. The other options mix in dividends or net income, or apply the wrong discount rate, which does not align with the standard DCF framework.