Discounted Cash Flow

Discounted cash flow (DCF) analysis values a stock (or any investment) as the present value of all expected future cash flows. It is more general than the dividend discount model (DDM) because it can use free cash flow, not just dividends, making it applicable to any company, including those that do not pay dividends.

Think of it this way: A dollar you receive next year is worth less than a dollar today, because you could invest today's dollar and earn a return. DCF takes every dollar a company is expected to generate in the future, adjusts each one for this time-value-of-money effect, and adds them up. The total is the stock's intrinsic value.

Core Formula

• r = discount rate (required rate of return)
• n = number of periods in the future

Terminal Value

A DCF model cannot project cash flows forever. In practice, analysts forecast cash flows explicitly for a forecast period (typically 5 to 10 years), then capture everything after that window in a single number called terminal value.

Terminal value is the present value of all cash flows that occur after the explicit forecast period. It treats the post-forecast cash flows as a growing perpetuity, using the Gordon Growth Model:

• FCF_final = free cash flow in the last explicitly projected year
• g = long-term growth rate (assumed constant forever)
• r = discount rate

Total DCF value is the sum of the discounted explicit-period cash flows plus the discounted terminal value. Because terminal value compresses decades of future cash flows into one number, it often represents 60 to 80 percent of the total DCF valuation (sometimes more).

Exam Tip: Gotchas

• Terminal value is usually the largest component of a DCF. If a question asks which part of a DCF model represents cash flows "beyond the forecast period" or is "often the largest component," the answer is terminal value.
• Small changes in g or r move terminal value a lot. Both appear in the denominator (r − g), so a 1 percent change in either has an outsized effect on the result.

DCF vs. DDM

DDM is actually a specific type of DCF that uses dividends as the cash flow. DCF is the broader, more flexible model.

Exam Tip: Gotchas

• DCF is the broader concept; DDM is a specific type of DCF. If a question says "present value of all future cash flows," the answer is DCF. If it specifically says "present value of all future dividends," the answer is DDM.

Key Relationships

• Higher discount rate (required return) = lower present value = lower intrinsic value
• Higher expected cash flows = higher present value = higher intrinsic value
• Longer time horizon = greater impact of discounting on distant cash flows
• If intrinsic value > market price, the stock is considered undervalued (buy signal)
• If intrinsic value < market price, the stock is considered overvalued (sell signal)

Exam Tip: Gotchas

• A higher discount rate lowers intrinsic value. When a question raises the required rate of return (or risk premium) without changing cash flows, the DCF valuation must FALL. This is the most commonly tested sensitivity in DCF problems.

Enterprise Value to Equity Value

• DCF typically produces an enterprise value (value of the entire business)
• Subtract net debt (total debt minus cash) to get equity value
• Divide equity value by shares outstanding to get intrinsic value per share

Comparison of All Four Valuation Methods