skills/dcf-model-builder/references/valuation-judgment.md

# Valuation Judgment Guide

## Purpose

Use this reference to apply senior investor judgment rather than merely building mathematically correct schedules.

A DCF is an argument about future cash generation, risk, reinvestment, and durability. The formulas matter, but the assumptions determine whether the model is useful.

## Senior judgment standard

Before accepting a DCF conclusion, challenge:

- Is the forecast economically plausible?
- Does the model explain how growth is achieved?
- Does margin expansion require credible scale, mix, pricing, or cost structure logic?
- Does the company reinvest enough to support the forecast?
- Does working capital absorb cash as the business grows?
- Does ROIC improve for a reason, or just because the model says so?
- Does terminal value assume a business that is better than the forecast supports?
- Are downside cases meaningfully adverse?
- Are cross-checks consistent with the DCF conclusion?

## Forecast challenge framework

### Revenue

Do not accept revenue growth as a blind CAGR when a driver model is possible.

Prefer drivers such as:

- customers x ARPU
- volume x price
- stores x sales per store
- units x ASP
- bookings x conversion x retention
- assets x utilization x yield
- market size x share
- contracted revenue x renewals x new business

Challenge revenue assumptions for:

- market size constraints
- share gains with no competitive explanation
- price increases unsupported by pricing power
- volume growth beyond capacity
- churn, retention, or renewal assumptions that are too optimistic
- growth that ignores cyclicality or normalization

### Margins

Margin assumptions should reflect business mix, scale, input costs, labor, pricing, automation, utilization, and competitive pressure.

Challenge:

- gross margin expansion without mix or cost logic
- EBITDA margin above peers without explanation
- sudden step-ups that do not tie to a cost program
- cost cuts that do not affect growth capacity
- terminal margins that exceed sustainable competitive economics

### Taxes

Tax assumptions should match the method and fact pattern.

Challenge:

- FCFF taxes calculated after interest expense
- cash taxes assumed equal to GAAP taxes when NOLs, credits, or timing differences matter
- losses that never create NOLs or valuation allowance implications
- tax rates that ignore jurisdiction mix
- terminal tax rate that is inconsistent with normalized profitability

### Working capital

Working capital should reflect business mechanics, not just a percentage plugged into FCF.

Challenge:

- growth without receivables or inventory investment
- payables stretch treated as permanent free financing
- cash conversion cycle improving indefinitely
- negative working capital businesses treated like traditional inventory businesses
- step changes in working capital with no operating explanation

### Capex and D&A

Capex and D&A must be economically consistent.

Challenge:

- capex below maintenance needs in terminal years
- high growth with no growth capex
- D&A exceeding or falling below capex in ways that imply unexplained asset aging
- terminal FCF boosted by starving capex
- asset-light businesses modeled as capital intensive without reason, or vice versa

### ROIC and reinvestment

Use ROIC as a reality check.

Challenge:

- ROIC rising far above WACC without a moat or fade logic
- growth continuing with declining reinvestment
- margin and capital intensity assumptions that create unrealistic value creation
- terminal ROIC that implies permanent excess returns without competitive defense

## Terminal value challenge

Terminal value often drives most of a DCF. Treat it as a primary valuation assumption, not a back-end formula.

Challenge:

- terminal growth above sustainable long-term economic growth
- terminal margins above what the business can defend
- terminal year not normalized
- exit multiple inconsistent with terminal growth, margins, and ROIC
- terminal value share so high that near-term forecast discipline barely matters
- using an exit multiple without explaining what buyers would pay and why

## Downside case quality

A downside case should test the thesis, not simply make the base case slightly less optimistic.

A credible downside should consider:

- slower growth
- weaker pricing
- margin compression
- customer churn or volume decline
- working capital drag
- higher capex or reinvestment
- higher cost of capital
- lower exit multiple or terminal growth
- delayed operating improvements

Flag a downside case as weak if it still assumes successful execution of all major initiatives.

## Investment committee lens

When summarizing the DCF, answer:

- What has to be true for the valuation to be right?
- Which assumptions are most debatable?
- What is the downside if management misses plan?
- What is the valuation floor from more conservative assumptions?
- What non-DCF evidence supports or contradicts the conclusion?
- What diligence should be done before relying on the model?

## Red flags

Treat these as issues requiring disclosure or revision:

- unsupported terminal value assumptions
- WACC selected to make the valuation work
- management case used as base case without challenge
- no downside case
- sensitivities that do not cover the real value drivers
- equity bridge missing debt-like items
- share count not diluted or not current
- terminal-year FCF boosted by unsustainably low capex or working capital
- valuation conclusion presented without range or caveats

## Public Equity PM Valuation Overlay

A DCF is useful for this plugin only if it translates into common-equity judgment. Require current price versus DCF-implied value, reverse DCF / market-implied expectations, consensus bridge, upside/downside to spot, target-price implication, dilution/SBC treatment, and falsifiers. Distressed recovery, restructuring waterfall, debt-security valuation, or credit-spread relative value routes to Credit Markets; retain only the common-equity downside implication here.