DCF model checks: 8 mistakes that change the value
Most DCF errors come from eight places: a terminal growth rate at or above the discount rate, a discount rate that does not match the cash flow, missing tax or reinvestment, wrong timing of cash flows, working capital moving the wrong way, double-counted cash or debt, the wrong share count, and a terminal value that is most of the answer without anyone noticing.
The eight checks
| Check | What to look for | Why it matters |
|---|---|---|
| Terminal growth | Long-run growth is below the discount rate and close to long-run inflation plus real growth | At growth = discount rate the Gordon formula divides by zero |
| Discount rate match | Free cash flow to the firm uses WACC; cash flow to equity uses cost of equity | Mixing them over- or under-values the business |
| Tax and reinvestment | Cash flow is after tax, capex and working capital | Profit is not cash |
| Timing | Year-end or mid-year discounting is chosen on purpose and used everywhere | Mid-year adds roughly half a year of discounting back |
| Working capital sign | A rise in receivables or stock reduces cash | A sign flip turns a cash drain into a gain |
| Bridge to equity | Net debt, leases and minorities are taken off once | Double counting moves value per share |
| Share count | Diluted shares, including options in the money | Value per share is wrong otherwise |
| Terminal value share | Show what % of value comes from the terminal value | Often 60-80%: the answer rests on one assumption |
A worked example
Year-5 free cash flow 100, discount rate 9%, terminal growth 3%: terminal value = 100 x 1.03 / (0.09 - 0.03) = 1,717. Change growth to 4% and it becomes 2,080 - over 20% more from one input. That is why the sensitivity table (growth across, discount rate down) belongs next to every DCF answer.
Quick self-test
Set growth to 0% and the discount rate up 2 points. If the value per share barely moves, a link is probably broken. If the balance sheet stops balancing, the DCF is reading from the wrong place.
Questions
- What terminal growth rate is normal?
- Many analysts use something near long-run inflation, often 2-3% for developed markets. It must stay below the discount rate.
- Should I use mid-year discounting?
- It assumes cash arrives evenly through the year. Either choice can be fine; what matters is using one choice everywhere and saying so.
- Can a DCF be checked automatically?
- The mechanics can: signs, links, growth vs discount rate. Whether the forecast is realistic needs a person.
Sources
- Aswath Damodaran (NYU Stern), valuation data and notes
- CFA Institute, free cash flow valuation (curriculum overview)
See the Excel model check
We check DCF and three-statement models cell by cell and list each issue with the fix.