Financial Management · Nature and purpose of the valuation of business and financial assets

Cash Flow Based Valuation: DCF and Free Cash Flow

Q: What is the difference between FCFF and FCFE?

FCFF is the cash flow available to all providers of finance, before interest. FCFE is what remains for shareholders after interest, tax and net borrowing movements. FCFF is discounted at WACC and FCFE at the cost of equity.

Q: How is DCF valuation different from the dividend valuation model?

The dividend valuation model discounts dividends, which depend on the payout policy. DCF discounts free cash flow, which shows what the business could pay out. DCF is better for firms that pay low or no dividends or for valuing a whole business.

Q: How do I calculate terminal value in a DCF?

Take the final forecast year cash flow, grow it by one year, and divide by the discount rate minus the growth rate. Then discount the result back using the final year's discount factor. The discount rate must be higher than the growth rate.

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

No. FCFE is already after interest and debt movements, and it is discounted at the cost of equity. The result is the equity value directly.

Updated 11 October 2026 · Fact-checked

Cash flow based valuation finds the value of a business by discounting its future free cash flows at a cost of capital that matches the risk. Discount free cash flow to the firm at WACC to get firm value, then deduct debt. Discount free cash flow to equity at the cost of equity to get equity value directly.

Understand Cash Flow Based Valuation (DCF and Free Cash Flow)

A business is worth the cash it will generate for its investors, adjusted for timing and risk. DCF valuation applies the same logic as NPV. You forecast cash flows, discount them, and add them up. The only difference is that you are valuing the whole business, not one project.

The cash flow you use is free cash flow: cash left after the business has paid tax and made the investment needed to keep operating and growing. Free cash flow to the firm (FCFF) is available to all providers of finance, both lenders and shareholders. Free cash flow to equity (FCFE) is what is left for shareholders after interest, tax and net debt movements.

The discount rate must match the cash flow. FCFF is discounted at the WACC, because it belongs to all investors. This gives the value of the firm (enterprise value). You then subtract the market value of debt to get the value of equity. FCFE is discounted at the cost of equity, because only shareholders receive it. This gives equity value directly.

Forecasts cannot run forever, so you forecast explicit years (often 3 to 5) and then add a terminal value (also called continuing value). The usual method treats the cash flow after the last forecast year as growing at a constant rate for ever, using a perpetuity-growth formula. Terminal value is often the largest part of the total, so small changes in growth or the discount rate move the answer a lot.

Compared with the dividend valuation model, DCF does not need dividends to be predictable. Dividends are a policy choice. Free cash flow shows what the business could pay out. This makes DCF useful for companies that pay no dividends or when valuing a whole business for an acquisition.

Key rules to remember

Free cash flow to the firm (FCFF): FCFF = operating cash flow after tax − net investment in non-current assets − increase in working capital; Before interest. Tax is normally the tax on operating profit. Use the data the question gives you; follow its definition of free cash flow.
Free cash flow to equity (FCFE): FCFE = FCFF − interest × (1 − tax rate) + net new borrowing (new borrowing less repayments); This is after interest and debt movements. Net new borrowing already nets repayments against new borrowing, so do not deduct repayments again. Equivalent to cash available to pay dividends.
Value of the firm: Firm value = Σ FCFF ÷ (1 + WACC)^t + terminal value discounted; Discount at WACC.
Value of equity from firm value: Equity value = firm value − market value of debt; Use market value of debt, not book value, if given.
Equity value from FCFE: Equity value = Σ FCFE ÷ (1 + Ke)^t + terminal value discounted; Discount at the cost of equity. No debt deduction needed.
Terminal value (growing perpetuity): TV at end of year n = CF(n+1) ÷ (r − g) = CF(n) × (1 + g) ÷ (r − g); Needs r > g. Discount TV by (1 + r)^n, the same factor as the year n cash flow.
Value per share: Value per share = equity value ÷ number of shares; Final step for share price questions.

How to solve Cash Flow Based Valuation (DCF and Free Cash Flow) questions

Use this order for any DCF valuation question. It keeps the discount rate matched to the cash flow.

1Decide what you are valuing: the firm (FCFF at WACC) or equity (FCFE at cost of equity).
2Lay out the forecast cash flows year by year. Check that they are free cash flows: after tax, after reinvestment, with working capital changes included. Remove non-cash items such as depreciation if you start from profit.
3Choose the discount rate. WACC for FCFF, cost of equity for FCFE. Calculate it if the question does not give it.
4Calculate the terminal value at the end of the last forecast year using CF × (1 + g) ÷ (r − g), if growth in perpetuity is assumed.
5Discount each forecast cash flow and the terminal value. Use the year-n factor for the terminal value.
6Add the present values to get firm value (or equity value for FCFE).
7If you valued the firm, subtract the market value of debt to get equity value. Divide by shares if asked for a share price.
8Comment where asked: assumptions about growth, sensitivity of terminal value, and any limitations.

Quickest way: Table, terminal value, subtract debt

When to use it: Use in the constructed response section when time is short and the question gives cash flows and a discount rate.

Write one line: 'FCFF at WACC, then less debt' or 'FCFE at Ke'.
Calculate the terminal value first and note it.
Add the terminal value to the final year cash flow in the table, then discount that single total with the year-n factor.
Sum the present values. Subtract debt last and divide by shares only if asked.
Write one or two assumptions as comments to pick up easy marks.

Common mistakes in Cash Flow Based Valuation (DCF and Free Cash Flow)

Discounting FCFF at the cost of equity, or FCFE at WACC.
Students remember a discount rate but forget which investors the cash flow belongs to.
Fix: Match them: all investors' cash flow with WACC, shareholders' cash flow with the cost of equity.
Forgetting to deduct debt after valuing the firm with FCFF.
The discounted total looks like a final answer.
Fix: Add a line 'less market value of debt' every time you use FCFF. Cash surplus, if given, may be treated as reducing net debt.
Discounting the terminal value by the wrong number of years.
The perpetuity formula gives a value one year after the last cash flow, which confuses the timing.
Fix: With CF(n) × (1 + g) ÷ (r − g) you get the value at the end of year n. Discount it with the year n factor.
Including depreciation as a cash outflow, or interest in FCFF.
Profit figures are used without adjustment.
Fix: Start from operating profit, add back depreciation, deduct tax, capital expenditure and working capital increase. Leave interest out of FCFF.
Using a growth rate equal to or above the discount rate.
Students plug in numbers without checking sense.
Fix: Check g < r. The perpetuity formula only works then, and long-run growth should be modest.
Subtracting the whole working capital balance instead of the increase.
Confusion between a balance and a cash movement.
Fix: Only the change in working capital each year affects cash flow.

Worked examples

Example 1

Bexa Co forecasts free cash flow to the firm of $4m in year 1 and $5m in year 2. After year 2, FCFF is expected to grow at 3% a year for ever. WACC is 10%. Bexa has debt with a market value of $15m and 4 million shares. Estimate the value per share.

Show the solution

Value the firm: FCFF at WACC, then subtract debt.
Terminal value at end of year 2 = 5 × 1.03 ÷ (0.10 − 0.03) = 5.15 ÷ 0.07 = $73.571m.
PV of year 1 = 4 ÷ 1.10 = $3.636m.
PV of year 2 = 5 ÷ 1.21 = $4.132m.
PV of terminal value = 73.571 ÷ 1.21 = $60.803m.
Firm value = 3.636 + 4.132 + 60.803 = $68.571m.
Equity value = 68.571 − 15 = $53.571m.
Value per share = 53.571 ÷ 4 = $13.39.

Answer: Equity value is about $53.57m, or about $13.39 per share.

Example 2

Cora Co expects free cash flow to equity of $3m in year 1 and $3.6m in year 2. After that FCFE grows at 4% a year for ever. Cost of equity is 12%. There are 5 million shares. Value the equity and the share.

Show the solution

FCFE is discounted at the cost of equity. No debt deduction is needed.
Terminal value at end of year 2 = 3.6 × 1.04 ÷ (0.12 − 0.04) = 3.744 ÷ 0.08 = $46.8m.
PV of year 1 = 3 ÷ 1.12 = $2.679m.
PV of year 2 = 3.6 ÷ 1.2544 = $2.870m.
PV of terminal value = 46.8 ÷ 1.2544 = $37.308m.
Equity value = 2.679 + 2.870 + 37.308 = $42.857m.
Value per share = 42.857 ÷ 5 = $8.57.

Answer: Equity value is about $42.86m, or about $8.57 per share.

Exam tips

Write down which cash flow and which rate you are using before you calculate. This shows the marker the logic even if arithmetic slips.
In objective test questions, look for the trap: debt not yet deducted, or terminal value discounted for the wrong year.
Calculate the terminal value once and show the formula. Marks are usually awarded for method.
In written parts, discuss reliability: terminal value dominates, growth assumptions are uncertain, and the WACC may change as gearing changes.
If asked to compare with the dividend valuation model, say that DCF uses cash available rather than dividends actually paid.

Practice questions from Nature and purpose of the valuation of business and financial assets