Financial Management · Models for the valuation of shares

Cash Flow Based Valuation and Free Cash Flow to Equity

Updated 11 October 2026 · Fact-checked

Cash flow based valuation finds the present value of a business's future free cash flows. Discount free cash flow to the firm at WACC to get enterprise value, then deduct debt. Or discount free cash flow to equity at the cost of equity to get equity value directly. Add a terminal value after the forecast period.

Understand Cash Flow Based Valuation and Free Cash Flow to Equity

A business is worth what it will pay its investors in cash, discounted for time and risk. This is the same logic as NPV. Instead of one project, you value the whole business.

Free cash flow to the firm (FCFF) is the cash left after operating costs, tax, capital investment and working capital needs. It belongs to all providers of finance, both lenders and shareholders. You discount it at the WACC. The result is the enterprise value. Deduct the market value of debt (and other claims such as preference shares) to get the equity value.

Free cash flow to equity (FCFE) is the cash left for shareholders after interest, tax, investment and net borrowing. You discount it at the cost of equity. The result is the equity value directly. Do not deduct debt again, because interest and debt movements are already in the cash flows.

You can only forecast a few years. The business is expected to continue beyond that, so you add a terminal value at the end of the forecast. The usual method is a growing perpetuity: the next year's cash flow divided by (discount rate − growth rate). Then discount the terminal value back to today using the factor for the final forecast year.

The discount rate must match the cash flow. FCFF goes with WACC. FCFE goes with the cost of equity, which is higher than the cost of debt and carries the financial risk of gearing. Mixing them is the most common error in this topic.

Key rules to remember

Free cash flow to the firm: FCFF = operating profit after tax + depreciation − capital investment − increase in working capital; Before interest. Tax is on operating profit. Use a working capital decrease as an inflow.
Free cash flow to equity: FCFE = FCFF − interest after tax + net new borrowing; Net new borrowing is new debt less repayments. It can be negative.
Terminal value (growing perpetuity): TV at end of year n = FCF(n+1) ÷ (r − g) = FCF(n) × (1 + g) ÷ (r − g); Needs r > g. Use WACC for FCFF and the cost of equity for FCFE. It gives a value at time n.
Enterprise value: Enterprise value = PV of FCFF at WACC (including terminal value); Discount each year's FCFF and the terminal value.
Equity value from enterprise value: Equity value = enterprise value − market value of debt (and preference shares); Use market value of debt where given. Add surplus cash if the question treats it separately.
Equity value from FCFE: Equity value = PV of FCFE at the cost of equity (including terminal value); Divide by number of shares for value per share.

How to solve Cash Flow Based Valuation and Free Cash Flow to Equity questions

Use this order for any free cash flow valuation question.

1Decide which cash flow you are using: FCFF (before debt flows) or FCFE (after interest and net borrowing). Read the question for which is given or asked.
2Pick the matching discount rate: WACC for FCFF, cost of equity for FCFE. Calculate it first if it is not given.
3List the cash flows by year. Adjust for tax, capital investment and working capital if you must build them.
4Calculate the terminal value at the end of the forecast: next year's cash flow ÷ (r − g). Check that r is greater than g.
5Discount every cash flow and the terminal value. Use the year-n factor for the terminal value.
6Add the present values. For FCFF, deduct debt to get equity value. For FCFE, the total is already equity value.
7Divide by the number of shares if asked for value per share. Compare with the current share price and comment on assumptions.

Quickest way: Calculator-friendly valuation

When to use it: Use it in Section A and B questions where you need one value fast, and in Section C to check your table.

Write the rate and growth rate at the top of your workings.
Work out the terminal value first, using the final year's cash flow × (1 + g) ÷ (r − g).
Add the terminal value to the final year's cash flow. Both use the same discount factor.
Discount each remaining year's cash flow with the given factors, or calculate each as cash flow ÷ (1 + r)^t.
Sum, then deduct debt only if you used FCFF.

Common mistakes in Cash Flow Based Valuation and Free Cash Flow to Equity

Discounting FCFE at WACC, or FCFF at the cost of equity.
Students remember the formulas but not which rate pairs with which cash flow.
Fix: FCFF belongs to all investors, so use WACC. FCFE belongs to shareholders only, so use the cost of equity. Write the pairing next to your first line.
Deducting debt from a value based on FCFE.
Students treat every valuation as enterprise value.
Fix: FCFE is already after interest and debt flows. The present value is equity value. Only deduct debt after discounting FCFF.
Discounting the terminal value at the wrong year.
The formula uses year n+1 cash flow, so students discount it by n+1 years.
Fix: The perpetuity formula gives the value at the end of year n. Discount it with the year-n factor.
Forgetting to grow the final cash flow by (1 + g).
Students divide the last forecast cash flow by (r − g).
Fix: The terminal value uses the next year's cash flow. Multiply the last forecast cash flow by (1 + g) unless the question already gives it.
Including interest in FCFF or depreciation as a cash outflow.
Students start from profit after interest and miss non-cash items.
Fix: Add back depreciation because it is non-cash. Keep interest out of FCFF. Include capital investment and working capital changes.
Writing a number with no comment on assumptions.
Students treat the answer as exact.
Fix: Terminal value is often most of the total. Say that the result is sensitive to growth, discount rate and forecast accuracy.

Worked examples

Example 1

Karan Co forecasts free cash flow to the firm of $10m, $12m and $14m in years 1 to 3. After year 3, FCFF grows at 3% a year forever. WACC is 10%. The market value of debt is $40m. Estimate the value of equity.

Show the solution

Use FCFF, so discount at WACC of 10%. Deduct debt at the end.
Terminal value at end of year 3 = 14 × 1.03 ÷ (0.10 − 0.03) = 14.42 ÷ 0.07 = $206.0m.
PV of year 1 = 10 ÷ 1.10 = $9.09m.
PV of year 2 = 12 ÷ 1.21 = $9.92m.
PV of year 3 = 14 ÷ 1.331 = $10.52m.
PV of terminal value = 206.0 ÷ 1.331 = $154.77m.
Enterprise value = 9.09 + 9.92 + 10.52 + 154.77 = $184.30m.
Equity value = 184.30 − 40 = $144.30m.

Answer: Enterprise value is about $184.3m. Equity value is about $144.3m. The terminal value is most of the enterprise value, so the result is sensitive to the growth and WACC assumptions.

Example 2

Meera Co has 10 million shares. Its free cash flow to equity is forecast at $5m, $5.5m and $6m in years 1 to 3, then grows at 4% a year forever. The cost of equity is 12%. Estimate the value per share.

Show the solution

Use FCFE, so discount at the cost of equity of 12%. No debt is deducted.
Terminal value at end of year 3 = 6 × 1.04 ÷ (0.12 − 0.04) = 6.24 ÷ 0.08 = $78.0m.
PV of year 1 = 5 ÷ 1.12 = $4.46m.
PV of year 2 = 5.5 ÷ 1.2544 = $4.38m.
PV of year 3 = 6 ÷ 1.404928 = $4.27m.
PV of terminal value = 78 ÷ 1.404928 = $55.52m.
Equity value = 4.46 + 4.38 + 4.27 + 55.52 = $68.64m.
Value per share = 68.64 ÷ 10 = $6.86.

Answer: Equity value is about $68.6m, or about $6.86 per share.

Exam tips

Read the first line of the question. If it gives FCFF, you need WACC and a debt deduction. If it gives FCFE, you need the cost of equity and no deduction.
In objective tests, the wrong options are often built from the usual mistakes: wrong rate, terminal value not discounted, or debt deducted twice. Check each step before you choose.
In Section C, set out a table with year, cash flow, factor and present value. Show the terminal value workings separately. Marks are given for method even if arithmetic slips.
Always add a short comment: terminal value dominates, growth must be below the discount rate, and forecasts are uncertain. Written points earn marks in constructed response questions.
If WACC must be calculated, do it first and show it. An error there carries through, but a clear method still earns marks.

Practice questions from Models for the valuation of shares

Cash Flow Based Valuation and Free Cash Flow to Equity in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Cash Flow Based Valuation and Free Cash Flow to Equity: frequently asked questions

What is the difference between FCFF and FCFE?

FCFF is the cash available to all providers of finance before interest and debt flows. FCFE is the cash left for shareholders after interest, tax and net borrowing. FCFF is discounted at WACC. FCFE is discounted at the cost of equity.

How do I calculate terminal value in ACCA FM?

Use a growing perpetuity. Divide the next year's cash flow by (discount rate − growth rate). This gives the value at the end of the forecast year. Discount it back with that year's factor.

Do I deduct debt when using free cash flow to equity?

No. FCFE is already after interest and net borrowing, so its present value is the value of equity. You only deduct debt when you have discounted FCFF to get enterprise value.

Which discount rate do I use for a business valuation?

Match the rate to the cash flow. Use WACC for FCFF and the cost of equity for FCFE. If the question gives a rate for the business as a whole, it is normally WACC.