Discounted Cash Flow | Series 65 Study Guide

Quick Answer

Discounted cash flow (DCF) values a stock, or any investment, as the present value of all expected future cash flows. Unlike the dividend discount model, DCF can use free cash flow instead of dividends, so it applies to any company, including one that pays no dividends. Terminal value usually dominates the total result.

DCF is the broader concept: the dividend discount model is a narrower special case of it that uses dividends specifically as the cash flow. Fundamental and technical analysis are separate analytical approaches, not special cases of DCF, though fundamental analysis may use DCF as one of its tools.

What Is the Core DCF Formula?

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.

\text{Intrinsic Value} = \sum_{t=1}^{n} \frac{\text{Cash Flow}_t}{(1 + r)^t}

r = discount rate (required rate of return)
n = total number of future periods being valued
t = each individual period, running from 1 up to n

How Do Analysts Project Free Cash Flow?

The cash flow figures that get discounted in the formula above do not appear on their own. An analyst has to project them, and those projections come from assumptions about the underlying business:

Revenue growth - how fast sales are expected to expand each year, based on historical trends, market conditions, and competitive position
Profit margins - how much of each revenue dollar converts to operating profit and, ultimately, cash
Capital expenditures - the spending on equipment, facilities, and other assets needed to maintain and grow the business

These three assumptions drive the free cash flow projection. Get them wrong and the entire DCF valuation is built on a bad foundation, no matter how carefully the discounting itself is done.

What Is Terminal Value, and Why Does It Dominate the Result?

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:

\text{Terminal Value} = \frac{\text{FCF}_{\text{final}} \times (1 + g)}{r - g}

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.

How Does DCF Compare to DDM?

Feature	Dividend Discount Model	Discounted Cash Flow
Cash flow used	Dividends only	Free cash flow (or any projected cash flow)
Best for	Stable dividend payers	Any company, including non-dividend payers
Scope	Equity holders only	Entire business (enterprise value)
Growth assumption	Constant dividend growth (Gordon)	Can model variable growth rates

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.

How Do Key Inputs Affect Intrinsic Value?

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.

How Do You Get from 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

How Do All Four Valuation Methods Compare?

Method	Data Used	Best For	Core Assumption
Technical analysis	Price and volume history	Short-term trading	Patterns repeat; price reflects all info
Fundamental analysis	Financial statements, economics	Active stock picking	Markets misprice; intrinsic value exists
Dividend discount	Expected dividends	Dividend-paying stocks	Value = present value of dividends
Discounted cash flow	Expected free cash flows	Any company	Value = present value of cash flows

What Should You Check on Exam Day?

Can you name terminal value as the largest single component of most DCF valuations and explain why (it captures decades of cash flow in one number)?
Can you predict the direction a DCF result moves when the discount rate rises, cash flow estimates rise, or the time horizon lengthens?
Can you walk from enterprise value to equity value to intrinsic value per share, in the correct order (subtract net debt, then divide by shares)?
Can you explain why DDM is a narrower special case of DCF rather than a separate, unrelated model?