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CFA Level I · CFA Level I Exam

Discounted Cash Flow (DCF) and Growth Models for CFA Level 1

Discounted cash flow valuation sets a share's value equal to the present value of its expected future cash flows. Dividend models discount dividends at the required return on equity. Free cash flow models discount FCFF at WACC or FCFE at the cost of equity. Identify the cash flow, match the discount rate, then discount.

What this chapter covers

This chapter covers equity valuation by discounting future cash flows. You start with the dividend discount model (DDM), where value is the present value of expected dividends. You then simplify it with the Gordon Growth Model for a constant growth rate, extend it to multistage models for firms whose growth changes over time, and link growth to fundamentals through the sustainable growth rate.

The second half moves from dividends to free cash flow. FCFF is cash available to all capital providers and is discounted at the weighted average cost of capital (WACC). FCFE is cash available to common shareholders only and is discounted at the required return on equity. The chapter ends with choosing a model that fits the company.

The chapter connects to much of the paper. It uses time value of money from Quantitative Methods, cost of capital and capital structure from Corporate Finance, and cash flow and earnings analysis from Financial Statement Analysis. It also sits beside the market-multiple methods in Equities, and the same present-value logic prices bonds in Fixed Income.

Valuation is the core skill of an analyst. These models appear mainly in Equities, and they draw on Corporate Finance (cost of capital) and Financial Statement Analysis, so one solid understanding earns marks in several places. Questions are standalone three-option items, often numerical, so you can win marks by setting up the formula correctly and eliminating options that reflect a common slip, such as using D0 instead of D1. Because there is no penalty for wrong answers, a fast, correct setup also lets you save time for harder questions elsewhere. The concepts are small in number but must be applied exactly. Practice pays off quickly here.

Discounted Cash Flow (DCF) and Growth Models: topics in the order to study them

  1. 1Dividend Discount Model (DDM) BasicsIt teaches the core idea that value is the present value of expected cash flows, and every later model builds on it.
  2. 2Gordon Growth ModelIt reduces the DDM to one formula, P0 = D1 ÷ (r − g), which you need for most calculations.
  3. 3Sustainable Growth Rate and Earnings RetentionIt explains where g comes from (retention rate × ROE), so you can use it inside the Gordon model.
  4. 4Multistage Dividend Discount ModelsOnce you know the constant-growth formula, you can chain it with a terminal value after a high-growth phase.
  5. 5Free Cash Flow to Firm and Equity (FCFF, FCFE)You move from dividends to free cash flow, so you must learn how each is built from net income, EBIT or CFO.
  6. 6Free Cash Flow Valuation ModelsIt applies the same constant and multistage logic to FCFF and FCFE, with WACC or cost of equity as the discount rate.
  7. 7Choosing and Applying Discount ModelsIt comes last because choosing a model needs you to know the strengths and limits of all the others.

How to prepare Discounted Cash Flow (DCF) and Growth Models

Build this chapter from one idea outward. Master the single-period logic first, then add growth, then add free cash flow. Practise with a calculator so setup becomes automatic.

  1. Write the general DDM as the sum of Dt ÷ (1 + r)^t and explain it in your own words before using any shortcut.
  2. Learn the Gordon formula P0 = D1 ÷ (r − g) and its conditions: g is constant forever and g < r. Practise questions that give D0, so you must compute D1 = D0 × (1 + g) first.
  3. Derive g = b × ROE, where b is the retention rate, and solve problems that give payout ratio instead of retention.
  4. For multistage models, draw a timeline. Discount each explicit dividend, then compute terminal value at the end of the high-growth period and discount it back. On the TI BA II Plus, use the CF worksheet and NPV to speed up the explicit cash flows.
  5. Memorise how FCFF and FCFE connect: FCFE = FCFF − Interest × (1 − tax rate) + Net borrowing. Practise starting from net income, EBIT and CFO.
  6. Do mixed sets where you must decide the cash flow, the discount rate and the model in one question. Review every wrong answer to find whether the error was in setup or arithmetic.
  7. In the last week, redo only the questions you missed and read your one-line revision points daily.

Common mistakes in Discounted Cash Flow (DCF) and Growth Models

  • Using D0 in the Gordon formula instead of D1.

    Fix: Always ask which date the dividend is for. Multiply D0 by (1 + g) unless the question already gives next year's dividend.

  • Applying the Gordon Growth Model when g is not below r, or when growth is not stable.

    Fix: Check g < r and that growth can continue indefinitely. If growth changes, use a multistage model.

  • Placing the terminal value at the wrong date.

    Fix: Draw a timeline. TVn = Dn+1 ÷ (r − g) sits at time n, and you discount it by n periods.

  • Discounting FCFF at the cost of equity, or FCFE at WACC.

    Fix: Link the cash flow to its claimants: FCFF to all capital providers uses WACC, FCFE to shareholders uses the cost of equity.

  • Forgetting to subtract debt (and add back cash where relevant) after an FCFF valuation.

    Fix: Remember that FCFF gives firm value. Subtract the market value of debt before dividing by shares.

  • Using the payout ratio as if it were the retention rate in g = b × ROE.

    Fix: Compute b = 1 − payout ratio first and write it down before multiplying by ROE.

Last-day revision: Discounted Cash Flow (DCF) and Growth Models

  • DDM: value today is the present value of all expected future dividends discounted at the required return on equity.
  • Gordon Growth Model: P0 = D1 ÷ (r − g), valid only when g is constant forever and r > g.
  • D1 = D0 × (1 + g). Check which dividend the question gives.
  • Sustainable growth rate g = retention rate b × ROE, where b = 1 − payout ratio.
  • Multistage: discount the explicit dividends, then discount the terminal value found at the end of the high-growth stage.
  • Terminal value at time n = Dn+1 ÷ (r − g), using the stable growth rate after stage one.
  • FCFF is discounted at WACC and gives firm value. Subtract debt to get equity value.
  • FCFE is discounted at the required return on equity and gives equity value directly.
  • FCFF = NI + NCC + Interest × (1 − t) − FCInv − WCInv.
  • FCFE = FCFF − Interest × (1 − t) + Net borrowing.
  • Higher r or lower g lowers value, and value is very sensitive when r is close to g.
  • Use DDM for dividend-paying, stable firms. Use FCFE or FCFF when dividends do not reflect cash generation.

Discounted Cash Flow (DCF) and Growth Models practice questions

Discounted Cash Flow (DCF) and Growth Models in other exams

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

Discounted Cash Flow (DCF) and Growth Models: frequently asked questions

Do I need to memorise all the DCF formulas for CFA Level I?

Yes, you should know the Gordon formula, g = b × ROE, and the FCFF and FCFE relationships, because you need them to set up calculations quickly. Understanding how each is built makes them easier to remember.

When should I use a multistage model instead of the Gordon Growth Model?

Use the Gordon model when growth is constant and expected to continue indefinitely, with g below r. If a company grows fast now and slows later, use a multistage model. It values the high-growth dividends explicitly and adds a terminal value.

What is the difference between FCFF and FCFE?

FCFF is cash available to all capital providers, both debt and equity holders, before financing payments. FCFE is the cash left for common shareholders after interest and net borrowing. FCFF is discounted at WACC, and FCFE at the required return on equity.

Can I use a calculator for multistage valuation questions?

Yes, the TI BA II Plus and HP 12C are approved. Enter the explicit cash flows in the cash flow worksheet and compute NPV at the required return. Add the discounted terminal value separately if you did not include it in the last cash flow.