Discounted Cash Flow (DCF)

The fundamental premise of a DCF is that the value of any asset is the sum of its future cash flows, discounted back to the present value at a rate that reflects the riskiness of those cash flows.

The Mathematical Architecture

• CF_t = Free Cash Flow in period t
• r = Discount Rate (typically WACC for firm valuation)
• n = Number of periods in the explicit forecast
• TV = Terminal Value

1. Projecting Free Cash Flow (FCFF vs FCFE)

Institutional models typically forecast Unlevered Free Cash Flow (FCFF) to value the entire enterprise, avoiding capital structure distortions.

2. Determining the Discount Rate

The discount rate represents the opportunity cost of capital. For FCFF, this is the Weighted Average Cost of Capital (WACC).

WACC blends the cost of equity (derived via CAPM) and the after-tax cost of debt, weighted by their respective market values in the capital structure.

3. Calculating Terminal Value

Because a company is a going concern, cash flows stretch to infinity. The Terminal Value captures the value of all cash flows beyond the explicit forecast period (usually 5-10 years).

Two primary methods exist:

1. Gordon Growth Model (Perpetuity Growth): Assumes cash flows grow at a constant rate forever. TV = CF_n+1 / (r - g). The growth rate (g) cannot exceed macroeconomic growth (GDP).
2. Exit Multiple Method: Applies a market multiple (e.g., EV/EBITDA) to the final year's metric. Highly sensitive to peer group selection.