Building the forecast and estimating WACC are only the inputs. The calculation stage — discounting explicit-period FCFFs, adding terminal value, bridging from enterprise value to equity value, and dividing by diluted shares — is where models break in subtle ways. McKinsey's Chapter 12 details the mid-year convention, the stub period, and the exact mechanics of converting EV to per-share intrinsic value.
The DCF calculation requires discounting each year's free cash flow back to the valuation date. The discount factor for year t is 1 / (1 + WACC)^t — but this assumes all cash flows arrive at the end of the year. In reality, businesses generate cash throughout the year. The mid-year convention corrects for this by discounting as if cash flows arrive at the midpoint: discount factor = 1 / (1 + WACC)^(t−0.5). For the terminal value (which is computed at the end of year T), the discount factor remains 1 / (1 + WACC)^T.
| Year | FCFF ($M) | End-Year PV Factor | End-Year PV ($M) | Mid-Year PV Factor | Mid-Year PV ($M) | Difference |
|---|---|---|---|---|---|---|
| Year 1 | $100 | 1/(1.10)^1 = 0.909 | $90.9 | 1/(1.10)^0.5 = 0.953 | $95.3 | +$4.4 |
| Year 2 | $100 | 1/(1.10)^2 = 0.826 | $82.6 | 1/(1.10)^1.5 = 0.867 | $86.7 | +$4.1 |
| Year 3 | $100 | 1/(1.10)^3 = 0.751 | $75.1 | 1/(1.10)^2.5 = 0.788 | $78.8 | +$3.7 |
| Year 4 | $100 | 1/(1.10)^4 = 0.683 | $68.3 | 1/(1.10)^3.5 = 0.716 | $71.6 | +$3.3 |
| Year 5 | $100 | 1/(1.10)^5 = 0.621 | $62.1 | 1/(1.10)^4.5 = 0.651 | $65.1 | +$3.0 |
| Sum (5-year PV) | — | — | $379.0 | — | $397.5 | +$18.5 (+4.9%) |
When a valuation date falls mid-year (e.g., June 30 valuation for a December 31 fiscal year), the first period's cash flow must be discounted for only half a year (the 'stub'). This applies in: (1) M&A transactions where deal close is expected mid-year; (2) any live valuation done at a non-fiscal-year-end date. McKinsey's guidance: annualize the partial year's FCFF proportionally, then apply the stub discount factor. Example: June 30 valuation with WACC = 10%, Year 1 FCFF = $100M (full year). Stub FCFF = $100M × 0.5 = $50M (H2 only). Stub discount factor = 1 / (1.10)^0.25 (because H2 midpoint is 3 months from valuation date). Forgetting the stub period overstates PV by pulling forward future cash flows.
Enterprise Value Calculation
EV = Σ [FCFF_t / (1+WACC)^(t−0.5)] + TV_T / (1+WACC)^T
Sum uses mid-year convention for explicit period FCFFs; terminal value is discounted at full T years since TV is computed at end of forecast period
| Component | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | Terminal |
|---|---|---|---|---|---|---|
| FCFF | $85 | $97 | $110 | $123 | $136 | — |
| Terminal Value | — | — | — | — | — | $2,040 (= $136 × 1.03 / (10%−3%)) |
| Discount Factor (mid-year for FCFFs; Year 5 for TV) | 0.953 | 0.867 | 0.788 | 0.716 | 0.651 | 0.621 |
| PV of Cash Flow | $81.0 | $84.1 | $86.7 | $88.1 | $88.6 | $1,266.8 |
| Cumulative PV | $81.0 | $165.1 | $251.8 | $339.9 | $428.5 | $1,695.3 |
In the above model, TV PV = $1,266.8M of a total EV of $1,695.3M = 74.7% of enterprise value. This is typical — for a growing business, 60%–80% of DCF value comes from terminal value. This concentration is not a flaw in the method; it is the mathematical consequence of the fact that most business value lies in cash flows beyond a 5-year explicit period. But it does mean: small changes in the terminal value assumption (WACC, g, or ROIC in the KVD formula) have enormous impact on EV. This is precisely why terminal value sensitivity analysis is mandatory.
Enterprise value is the total value of the business to all capital providers. Converting EV to equity value (what common shareholders own) requires adding claims that represent non-operating assets and subtracting claims senior to equity. Each adjustment must be done at market value, not book value — and the adjustments must be consistent with what was included (or excluded) from FCFF.
| Adjustment | Direction | Amount (Example) | Rationale |
|---|---|---|---|
| Enterprise Value (DCF) | Starting point | $1,695M | PV of all operating cash flows to all capital providers |
| + Cash and Short-Term Investments | Add | +$120M | Excess cash not needed for operations is a non-operating asset that belongs to equity; must not be in FCFF |
| + Investments and Affiliates (at market) | Add | +$45M | Minority-owned stakes; include only if not consolidated in FCFF and their cash flows not in the model |
| + Tax Loss Carryforwards (PV) | Add | +$30M | NOLs have real economic value — they reduce future cash taxes; often omitted, creating systematic undervaluation |
| − Total Debt (at market value) | Subtract | ($450M) | All interest-bearing debt: term loans, bonds, notes — includes current portion; use market value where possible |
| − Capital Leases (at PV of future payments) | Subtract | ($55M) | Post-IFRS 16/ASC 842: leases are on balance sheet; must be subtracted like debt; lease payments not in FCFF if leases are excluded from NOPAT |
| − Underfunded Pension Obligations (at market) | Subtract | ($80M) | If pension costs are in NOPAT (as they should be), the unfunded PBO is a debt-like claim against equity |
| − Minority Interests (at market) | Subtract | ($40M) | Minority shareholders' claim on consolidated subsidiaries; EV includes 100% of consolidated subsidiary cash flows |
| − Preferred Stock (at liquidation value) | Subtract | ($0M) | Senior equity claim; subtract before arriving at common equity value |
| = Equity Value to Common Shareholders | Result | $1,265M | Total value to common equity holders |
| ÷ Diluted Shares Outstanding | Divide | 75M shares | Treasury stock method; includes options and unvested RSUs |
| = Intrinsic Value Per Share | Result | $16.87 | Compare to current market price to assess over/undervaluation |
Key Takeaways
A 5-year DCF model produces explicit-period FCFFs of $50M, $60M, $70M, $80M, $90M. WACC = 12%. Terminal value (end of Year 5) = $1,200M. Using mid-year discounting for explicit-period cash flows and end-year for TV, what is enterprise value?