Strategic Performance Management and Business Valuation · Business Valuation Methods and Approaches

DCF Valuation: FCFF, FCFE and Terminal Value

Updated 11 October 2026 · Fact-checked

DCF valuation finds the value of a business by discounting its expected future cash flows to today. Forecast FCFF, discount at WACC, add a discounted terminal value, then subtract debt to get equity value. For FCFE, discount at cost of equity and the result is equity value directly.

Understand Income Approach: DCF Valuation

A business is worth what it will earn for its owners in the future, expressed in today's rupees. A rupee received later is worth less than a rupee today, and risky cash is worth less than safe cash. Discounted cash flow (DCF) valuation applies both ideas: forecast cash flows, then discount them at a rate that reflects risk.

There are two cash flow measures. FCFF (free cash flow to the firm) is the cash available to all capital providers, both lenders and shareholders. FCFE (free cash flow to equity) is the cash left for shareholders after paying interest, repaying debt and funding reinvestment. The cash flow and the discount rate must match. FCFF goes with WACC and gives enterprise value. FCFE goes with cost of equity and gives equity value.

Forecasts cannot run forever, so you forecast explicitly for a period, usually 3 to 10 years. After that you add a terminal value (TV), which captures all cash flows beyond the forecast. The usual method is the Gordon growth model, which assumes cash flows grow at a steady rate g for ever. An alternative is an exit multiple. TV is often the largest part of the value, so g must be modest, normally not above long-run nominal growth of the economy.

The capitalisation of earnings method is a simple version of the income approach. You take a maintainable (normalised) level of earnings or cash flow and divide it by a capitalisation rate. It suits stable businesses with steady earnings. You must first remove one-off items and adjust for abnormal expenses or incomes.

The discount rate is the cost of capital. Cost of equity is often found by CAPM. WACC weights the after-tax cost of debt and the cost of equity by their target capital structure, preferably at market values.

Key rules to remember

FCFF: FCFF = EBIT × (1 − t) + Depreciation − Capital expenditure − Increase in net working capital; EBIT×(1−t) is NOPAT. Use only non-cash charges that you add back. Alternative: CFO + Interest × (1 − t) − Capex.
FCFE: FCFE = Net income + Depreciation − Capex − Increase in net working capital + Net borrowing; Net borrowing = new debt raised − debt repaid. Also FCFE = FCFF − Interest × (1 − t) + Net borrowing.
Cost of equity (CAPM): Ke = Rf + β × (Rm − Rf); (Rm − Rf) is the market risk premium. Use the beta that fits the firm's leverage.
WACC: WACC = E/(D+E) × Ke + D/(D+E) × Kd × (1 − t); Debt cost is taken after tax. Use target or market value weights.
Present value of a cash flow: PV = CF ÷ (1 + r)^n; n is the year in which the cash flow arises.
Terminal value (Gordon growth): TV at year n = CF(n+1) ÷ (r − g) = CF(n) × (1 + g) ÷ (r − g); Needs r > g. TV sits at the end of year n, so discount it by (1 + r)^n.
Enterprise to equity value: Equity value = Enterprise value − Debt + Cash and surplus assets; Used with FCFF. Deduct debt at its market or book value as the question states.
Capitalisation of earnings: Value = Maintainable earnings ÷ Capitalisation rate; Capitalisation rate = discount rate − growth rate when earnings grow steadily.

How to solve Income Approach: DCF Valuation questions

Use this order for any DCF question. It keeps the cash flow, rate and value consistent.

1Read what is asked: enterprise value, equity value or value per share. Decide FCFF or FCFE from the data given.
2Compute the cash flow for each forecast year using the correct formula. Show each line.
3Choose the discount rate that matches: WACC for FCFF, cost of equity for FCFE. Compute it by CAPM or the given data.
4Find terminal value at the end of the last forecast year using the Gordon formula, or the exit multiple if given.
5Discount each year's cash flow and the terminal value to today. Use the year number as the power.
6Add the present values to get enterprise value (FCFF) or equity value (FCFE).
7For FCFF, deduct debt and add cash to reach equity value. Divide by shares if per-share value is needed.
8State the answer with units and one line on key assumptions, such as g and the discount rate.

Quickest way: Discount factor table and TV shortcut

When to use it: Use when the question gives a few years of cash flows and a constant growth rate after that.

Write the discount factors for years 1 to n once, rounded as the question allows.
Multiply each cash flow by its factor in one column. Total the column.
Compute TV = CF(n) × (1 + g) ÷ (r − g) in one line, then multiply by the year-n factor.
Add the two totals. Make the debt and cash adjustment last.
Check that r > g and that the TV share of value looks sensible.

Common mistakes in Income Approach: DCF Valuation

Discounting FCFF at the cost of equity, or FCFE at WACC.
Students remember the formulas but not the pairing.
Fix: FCFF is for all capital providers, so use WACC. FCFE is for shareholders only, so use cost of equity.
Using the year-n cash flow instead of year n+1 in the terminal value.
The formula is memorised as CF ÷ (r − g).
Fix: Multiply the last forecast cash flow by (1 + g) first. Then discount TV by the year-n factor, not n+1.
Forgetting to subtract debt after valuing with FCFF.
The sum of present values looks like the final answer.
Fix: FCFF gives enterprise value. Subtract debt and add surplus cash before quoting equity value or per-share value.
Adding back interest or using the wrong tax treatment in FCFF.
Students start from net income, which is already after interest.
Fix: Start from EBIT × (1 − t) for FCFF. Interest tax shield is captured in WACC, not in the cash flow.
Ignoring working capital and capex or deducting the whole working capital instead of the increase.
Focus is on profit, not cash.
Fix: Deduct only the increase in net working capital and all capex. Add back depreciation only.
Using a growth rate that is equal to or above the discount rate.
Students plug in the given growth without checking.
Fix: Check r > g. A terminal growth rate should be low and sustainable.

Worked examples

Example 1

A company expects FCFF of ₹40 lakh, ₹44 lakh and ₹48 lakh in years 1, 2 and 3. After year 3, FCFF grows at 5% a year for ever. WACC is 15%. Debt is ₹100 lakh and there is no surplus cash. Find the enterprise value and equity value. Use discount factors at 15%: year 1 = 0.8696, year 2 = 0.7561, year 3 = 0.6575.

Show the solution

PV of explicit cash flows: 40 × 0.8696 = 34.784; 44 × 0.7561 = 33.268; 48 × 0.6575 = 31.560.
Total = 34.784 + 33.268 + 31.560 = 99.612 lakh.
Terminal value at end of year 3 = 48 × 1.05 ÷ (0.15 − 0.05) = 50.4 ÷ 0.10 = 504 lakh.
PV of TV = 504 × 0.6575 = 331.38 lakh.
Enterprise value = 99.612 + 331.38 = 430.99 lakh, about ₹431 lakh.
Equity value = 430.99 − 100 = 330.99 lakh.

Answer: Enterprise value is about ₹431 lakh and equity value is about ₹331 lakh.

Example 2

A stable firm has maintainable after-tax earnings of ₹60 lakh. A buyer requires a return of 16% and expects earnings to grow at 4% a year for ever. Value the business by capitalisation of earnings, using next year's earnings as the earnings figure. Then find the value if the buyer instead uses 12% as a plain capitalisation rate on ₹60 lakh.

Show the solution

Capitalisation rate with growth = 16% − 4% = 12%.
Next year's earnings are given as ₹60 lakh, so no growth uplift is needed.
Value = 60 ÷ 0.12 = ₹500 lakh.
Second case: plain rate of 12% on ₹60 lakh gives 60 ÷ 0.12 = ₹500 lakh.
Both approaches agree because the growth-adjusted rate is also 12%.

Answer: The value is ₹500 lakh under both approaches.

Exam tips

Write the cash flow build-up line by line. Marks are given for each correct component even if the final figure is wrong.
State your discount rate and its source (CAPM or given). Always say why FCFF goes with WACC.
Show the terminal value separately and its discounting year. Examiners check this step closely.
In case-based answers, comment on how sensitive value is to g and the discount rate, then give a clear conclusion.
For MCQs, check the pairing and the debt adjustment first. Many wrong options differ only on these points.

Practice questions from Business Valuation Methods and Approaches

Income Approach: DCF Valuation: frequently asked questions

What is the difference between FCFF and FCFE?

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

How do you calculate terminal value in DCF?

With the Gordon growth model, TV = last forecast cash flow × (1 + g) ÷ (r − g). It is stated at the end of the last forecast year. You then discount it back using that year's discount factor. An exit multiple method may be used if the question gives a multiple.

When should I use capitalisation of earnings instead of DCF?

Use it when earnings are stable and expected to continue or grow at a steady rate. It is a single-period shortcut. If cash flows change a lot over the years, a multi-year DCF is more reliable.

Which discount rate do I use for DCF?

Match it to the cash flow. Use WACC for FCFF and cost of equity for FCFE. The rate should reflect the risk of the business and its capital structure.