300 lines
7.3 KiB
Markdown
300 lines
7.3 KiB
Markdown
# DCF Modeling Best Practices
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## Overview
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Discounted Cash Flow (DCF) analysis is the foundation of corporate valuation. This guide outlines best practices for building professional DCF models.
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## Model Structure
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### 1. Assumptions Sheet
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**Layout:**
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```
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Company Information
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├── Name
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├── Ticker
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├── Base Year
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└── Fiscal Year End
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Revenue Assumptions
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├── Base Year Revenue
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├── Year 1-5 Growth Rates
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└── Terminal Growth Rate
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Profitability Assumptions
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├── EBITDA Margin %
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├── D&A as % of Revenue
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└── Tax Rate %
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Working Capital & CapEx
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├── NWC as % of Revenue
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└── CapEx as % of Revenue
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Discount Rate
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└── WACC %
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```
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**Best Practices:**
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- Color-code assumptions (blue = inputs, black = formulas)
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- Document all assumptions with sources
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- Use reasonable ranges (check industry averages)
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- Include sensitivity ranges for key variables
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---
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### 2. Free Cash Flow Projections
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**Calculation Flow:**
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```
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Revenue
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× EBITDA Margin
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= EBITDA
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- Depreciation & Amortization
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= EBIT
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× (1 - Tax Rate)
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= NOPAT (Net Operating Profit After Tax)
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+ Depreciation & Amortization (add back non-cash)
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- Capital Expenditures
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- Increase in Net Working Capital
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= Unlevered Free Cash Flow
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```
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**Key Formulas:**
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Revenue Projection:
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```excel
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=Base_Revenue * (1 + Growth_Rate_Y1) * (1 + Growth_Rate_Y2) * ...
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```
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Or year-by-year:
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```excel
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Year 1: =Base_Revenue * (1 + Growth_Rate_Y1)
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Year 2: =Year1_Revenue * (1 + Growth_Rate_Y2)
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```
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Free Cash Flow:
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```excel
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=NOPAT + DA - CapEx - Delta_NWC
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```
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**Best Practices:**
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- Link all formulas to Assumptions sheet
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- Never hard-code values in projection sheet
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- Use consistent time periods (fiscal years, not calendar)
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- Check that FCF is positive by Year 3-5
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---
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### 3. Valuation Calculations
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**Present Value of FCF:**
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```excel
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PV_Year1 = FCF_Year1 / (1 + WACC)^1
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PV_Year2 = FCF_Year2 / (1 + WACC)^2
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...
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PV_Year5 = FCF_Year5 / (1 + WACC)^5
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Sum_PV_FCF = SUM(PV_Year1:PV_Year5)
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```
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**Terminal Value:**
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```
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Gordon Growth Model:
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TV = FCF_Year5 * (1 + Terminal_Growth) / (WACC - Terminal_Growth)
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PV_TV = TV / (1 + WACC)^5
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```
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**Enterprise Value:**
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```
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EV = Sum_PV_FCF + PV_TV
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```
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**Equity Value:**
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```
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Equity Value = EV - Net Debt + Non-Operating Assets
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```
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**Best Practices:**
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- Terminal value typically 60-80% of EV (if >80%, revisit assumptions)
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- Terminal growth rate usually 2-3% (long-term GDP growth)
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- WACC typically 7-15% depending on industry and risk
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- Always sanity-check: Does the implied valuation make sense vs comps?
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---
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### 4. Sensitivity Analysis
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**Two-Way Table:**
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- **Rows**: WACC (vary ±2% from base case)
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- **Columns**: Terminal Growth (vary from 1.5% to 3.5%)
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- **Output**: Enterprise Value at each combination
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**Excel Data Table:**
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```excel
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1. Create table with WACC in left column, Terminal Growth in top row
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2. Reference Enterprise Value formula in top-left cell
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3. Select entire table
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4. Data → What-If Analysis → Data Table
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5. Row input: Terminal Growth cell
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6. Column input: WACC cell
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7. OK → Table populates automatically
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```
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**Best Practices:**
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- Use realistic ranges (don't test WACC of 1% or 50%)
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- Apply conditional formatting (green = high value, red = low value)
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- Add "base case" marker to highlight your primary assumption
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- Include 3-4 variations typically
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---
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## Common Assumptions by Industry
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### Technology (SaaS)
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- Revenue Growth: 20-40% (early stage), 10-20% (mature)
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- EBITDA Margin: 20-30%
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- WACC: 9-12%
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- Terminal Growth: 2.5-3%
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### Consumer Goods
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- Revenue Growth: 3-8%
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- EBITDA Margin: 15-25%
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- WACC: 7-9%
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- Terminal Growth: 2-2.5%
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### Healthcare
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- Revenue Growth: 5-12%
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- EBITDA Margin: 18-28%
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- WACC: 8-10%
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- Terminal Growth: 2.5-3%
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### Industrials
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- Revenue Growth: 3-7%
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- EBITDA Margin: 10-18%
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- WACC: 7-9%
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- Terminal Growth: 2-2.5%
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---
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## Validation Checks
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Before finalizing your DCF:
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### 1. Reasonableness Checks
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- [ ] Revenue CAGR is achievable (check historical and industry average)
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- [ ] EBITDA margin is in line with industry (check public comps)
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- [ ] CapEx as % of revenue is reasonable (3-5% typical, higher for growth)
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- [ ] Terminal growth ≤ Long-term GDP growth (2-3%)
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- [ ] WACC is appropriate for risk profile
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### 2. Mathematical Checks
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- [ ] Terminal growth < WACC (model breaks if g ≥ WACC)
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- [ ] All formulas link to Assumptions (no hard-coded values)
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- [ ] Sum of percentages = 100% where applicable
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- [ ] No circular references
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### 3. Output Checks
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- [ ] Terminal value is 60-80% of EV (not >90%)
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- [ ] Implied valuation is reasonable vs public comps
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- [ ] Sensitivity table shows reasonable range (not wild swings)
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- [ ] Sign of FCF is positive in out-years
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---
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## Common Mistakes to Avoid
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### 1. Over-Optimistic Growth
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❌ **Mistake**: Assuming 30% revenue growth indefinitely
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✅ **Fix**: Taper growth rates (30% → 20% → 15% → 10% → 5%)
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### 2. Ignoring Working Capital
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❌ **Mistake**: Setting NWC change to zero
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✅ **Fix**: Model NWC as % of revenue (typically 10-15%)
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### 3. Terminal Growth Too High
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❌ **Mistake**: Using 5% terminal growth
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✅ **Fix**: Use 2-3% (long-term GDP growth rate)
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### 4. Not Linking Formulas
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❌ **Mistake**: Hard-coding values in projection sheet
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✅ **Fix**: Link all cells to Assumptions sheet
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### 5. Ignoring CapEx
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❌ **Mistake**: Minimal CapEx assumption
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✅ **Fix**: Model realistic CapEx (3-5% of revenue, higher for growth companies)
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---
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## Advanced Techniques
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### 1. Multiple Scenarios
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Create 3 scenarios in separate columns:
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- **Base Case**: Most likely assumptions
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- **Upside**: Optimistic assumptions (+20% growth, +200bps margin)
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- **Downside**: Conservative assumptions (-20% growth, -200bps margin)
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### 2. Detailed Working Capital
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Instead of NWC as % of revenue, model components:
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- Days Sales Outstanding (DSO) for receivables
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- Days Inventory Outstanding (DIO) for inventory
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- Days Payables Outstanding (DPO) for payables
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### 3. Explicit CapEx Build
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Instead of CapEx as % of revenue, model:
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- Maintenance CapEx (keep operations running)
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- Growth CapEx (support revenue growth)
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- Total CapEx = Maintenance + Growth
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### 4. Multiple Exit Methods
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Calculate terminal value using both:
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- Gordon Growth Model (perpetuity method)
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- Exit Multiple Method (exit EV/EBITDA)
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Compare results for reasonableness.
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---
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## Formatting Standards
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### Colors
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- **Blue**: User inputs (assumptions)
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- **Black**: Formulas (calculations)
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- **Green**: Positive values (revenue, profit)
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- **Red**: Negative values (expenses, outflows)
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### Number Formats
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- **Currency**: $1,234,567 or $1.2M
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- **Percentages**: 15.0% (one decimal)
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- **Multipliers**: 10.5x (one decimal)
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### Structure
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- Freeze top row and left column
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- Bold headers
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- Borders around key sections
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- Subtotals and totals clearly labeled
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---
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## Resources & Further Reading
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### Industry Data
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- **CapIQ / Bloomberg**: For public company data
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- **PitchBook / Preqin**: For private company data
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- **Damodaran (NYU)**: Industry WACC and margin data
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### Academic Resources
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- **"Valuation" by McKinsey**: Industry standard textbook
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- **"Investment Valuation" by Aswath Damodaran**: Comprehensive guide
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- **CFA Institute**: DCF methodology resources
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### Online Tools
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- **Damodaran Online**: Free industry data and tools
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- **FRED (Federal Reserve)**: Economic data (GDP growth, interest rates)
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- **Yahoo Finance / Google Finance**: Public company financials
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---
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## Version History
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- v1.0.0 (2025-10-27): Initial best practices guide
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