What Is DCF? A Step-by-Step Valuation with TSMC

Concepts

The Time Value of Money

DCF stands for Discounted Cash Flow. To understand it, you first need to grasp a simple concept: $100 today is worth more than $100 a year from now.

Why? Because you can invest today's $100, and in a year it might grow to $105. So if someone promises you "$100 next year," that money is actually worth less than $100 in today's terms.

This process of converting future money into what it is worth today is called discounting.

The Four Key Components of DCF

DCF valuation has four core building blocks:

1. Free Cash Flow (FCF) The cash generated by a company's operations, minus the capital expenditures needed to maintain the business. This is the money that is truly "free" to be distributed.

FCF = Operating Cash Flow - Capital Expenditures

2. FCF Growth Rate The projected rate at which free cash flow will grow over the next several years. This is the part that requires the most judgment, typically estimated based on historical growth trends and the industry outlook.

3. WACC (Weighted Average Cost of Capital) The company's cost of capital, which serves as the discount rate. A higher WACC means future cash flows are worth less when converted back to today's value. It accounts for both the return shareholders demand and the interest cost of debt.

As a general guideline:

• Stable large-cap companies: WACC around 7-9%
• Growth companies: WACC around 9-12%
• High-risk startups: WACC may be 15% or higher

4. Terminal Value We cannot forecast infinitely into the future, so we typically project cash flows for 5-10 years and then use a "terminal value" to represent everything beyond that horizon. Terminal value usually accounts for 60-70% of the total valuation, making this assumption critically important.

Putting It All Together

The logic of DCF works like this:

1. Estimate free cash flow for each of the next 5-10 years
2. Discount each year's cash flow back to the present using the WACC
3. Add the terminal value (also discounted)
4. Sum everything up = the company's intrinsic value
5. Divide by total shares outstanding = fair value per share

If the calculated fair value is above the current stock price, the stock appears undervalued; if below, it appears overvalued.

Pros and Cons of DCF

Pros: It is not swayed by market sentiment — it values a company purely on its ability to generate cash. Cons: It is highly sensitive to assumptions. A 1% change in WACC or a 2% change in the growth rate can significantly alter the result. That is why DCF produces a "range" rather than a precise number.

Hands-On: Using CTSstock

1. Go to /analysis/2330 (using TSMC as an example)
2. Click the "Valuation" tab at the top
3. Find the DCF Valuation Calculator
4. You can adjust the following parameters:
   • WACC (discount rate): Set according to the company's risk level
   • FCF growth rate: Refer to historical growth rates and your outlook for the future
   • Terminal value multiple: Affects the long-term valuation assumption
   • Projection period: Typically set to 5-10 years
5. The system will automatically calculate a fair value per share for you to compare against the current stock price
6. Run multiple scenarios with different assumptions to arrive at a reasonable range, rather than relying on a single number

FAQ

Q: Is DCF suitable for every company? A: No. DCF works best for mature companies with stable, positive cash flows. If a company is still losing money or has highly volatile cash flows (e.g., startups), DCF results will be unreliable.

Q: Why do different analysts get very different results from the same DCF model? A: Because their assumptions differ. A 1-2% difference in the growth rate or a 1% difference in WACC can lead to results that diverge by 20-30%. The biggest challenge with DCF is not the formula — it is whether the underlying assumptions are reasonable.