DCF Valuation: Which Cash Flows Should You Discount, and at What Rate?
DCF depends on matching cash flows with the right discount rate. Hypothetical figures explain FCFF versus FCFE, discounting terminal value, and the bridge from enterprise value to equity value.
DCF converts future cash receipts into present values using a discount rate appropriate to their risk and timing, then adds them together. Free cash flow to the firm, FCFF, is discounted at the weighted average cost of capital, while free cash flow to equity, FCFE, is discounted at the cost of equity. The chosen approach also determines where debt is accounted for.
Move from the income statement to cash flow
For a typical nonfinancial company, FCFF can be structured as after-tax operating income plus noncash depreciation and amortization, minus capital expenditure and increases in operating working capital. Even as revenue and earnings grow, rising credit sales and inventory tie up cash. When raising growth assumptions, check that these reinvestment needs increase as well. FCFE reflects financing flows before cash reaches shareholders, including interest and net borrowing. Treating accounting net income as cash that can be distributed forever without further adjustment can overlook investment requirements.
Separate the explicit forecast period from terminal value
For the first few years, forecast revenue, margins, taxes, and investment year by year, then calculate terminal value on the assumption that the business stabilizes thereafter. Terminal value is measured at the end of the final forecast year and must be discounted back to the present. If growth is expected to slow, perpetuating the final year’s high growth and margins can inflate the result. Discount timing also differs depending on whether cash arrives at year-end or evenly throughout the year, so a simple model should clearly state that it uses a year-end convention.
Bridge operating value to the value of one common share
Discounted FCFF captures the value of the business generating operating cash flow. Add separately valued nonoperating cash and deduct interest-bearing debt and other claims to arrive at common-equity value. Then divide by a consistent share count to calculate value per share. If you discount FCFE directly, debt effects are already included in the cash flows, so avoid subtracting the same debt again. The model’s reliability depends less on decimal precision than on consistency among the cash flows, discount rate, and scope of the final valuation adjustments.
Worked example
Hypothetical example: Assume year-end FCFF of KRW 11 billion in one year and KRW 12.1 billion in two years, with a 10% discount rate. Their present values are KRW 10 billion each. If terminal value at the end of year 2 is separately assumed to be KRW 121 billion, its present value is KRW 100 billion, giving total operating value of KRW 120 billion. Subtracting net debt of KRW 20 billion leaves equity value of KRW 100 billion. The KRW 121 billion terminal value is an assumption used to illustrate the calculation.
What to check
- Have you specified whether you are discounting FCFF or FCFE?
- Have you included the facilities and working capital required for revenue growth?
- Have you discounted terminal value from the final year back to the present?
- Have you avoided deducting debt twice through cash flows and valuation adjustments?
Sources and primary materials
This is educational material about research methods. For an actual company decision, verify the filings and primary sources for the relevant period.