Discounted Cash Flow Method of Valuation

Understand Discounted Cash Flow Method

Key rules to remember

Free cash flow to firm (FCFF)

FCFF = EBIT × (1 − t) + Depreciation and amortisation − Capital expenditure − Increase in net working capital

EBIT × (1 − t) is NOPAT. Use the tax rate on operating profit. If working capital falls, add the decrease.

Cost of equity (CAPM)

Ke = Rf + β × (Rm − Rf)

Rf is the risk-free rate, β the equity beta, (Rm − Rf) the market risk premium. If the question gives Rm, deduct Rf from it.

After-tax cost of debt

Kd (after tax) = Kd (pre-tax) × (1 − t)

Interest is tax deductible, so the tax shield lowers the cost of debt.

WACC

WACC = [E ÷ (D + E)] × Ke + [D ÷ (D + E)] × Kd × (1 − t)

Use market-value weights, or target capital structure, if given. Use book values only if the question says so.

Present value of a cash flow

PV = CF ÷ (1 + r)ⁿ

n is the year of the cash flow. Year-end flows are assumed unless the question says otherwise.

Terminal value (Gordon growth)

TV at year N = FCFF(N) × (1 + g) ÷ (WACC − g)

Valid only when g is below WACC. g should be a long-term rate, not above the long-run growth of the economy.

Terminal value (exit multiple)

TV at year N = EBITDA(N) × Exit multiple

Use when the question gives a multiple. Discount it by N years, like the Gordon TV.

Enterprise value

EV = Σ [FCFF(t) ÷ (1 + WACC)ᵗ] + TV ÷ (1 + WACC)ᴺ

Sum over the explicit forecast years t = 1 to N.

Equity value and value per share

Equity value = EV − Debt − Preference capital − Minority interest + Cash and non-operating assets; Value per share = Equity value ÷ Number of shares

Deduct only the claims that the question lists. Do not deduct operating liabilities already in working capital.

How to solve Discounted Cash Flow Method questions

1. 1Read the data and note the valuation date, forecast period, tax rate, growth rate and what is given about debt, cash and shares.
2. 2Compute FCFF for each forecast year: EBIT × (1 − t) + depreciation − capex − increase in working capital. Show each year in a table.
3. 3Compute the discount rate. Find Ke by CAPM, the after-tax Kd, the capital weights, and then WACC. If WACC is given, use it directly.
4. 4Compute the terminal value at the end of the last forecast year, using the Gordon formula or the exit multiple. Check that g is less than WACC.
5. 5Discount every FCFF and the terminal value to today using (1 + WACC)ⁿ. Add them to get enterprise value.
6. 6Bridge to equity: deduct debt and other claims, add cash and non-operating assets. Divide by the number of shares if a per-share value is asked.
7. 7State your assumptions and conclude with a one-line answer. Add a brief comment on how sensitive the value is to WACC and g if the question asks for it.

Quickest way: Table-first DCF under time pressure

Common mistakes in Discounted Cash Flow Method

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

  Students forget that the discount rate must match the cash flow. FCFF belongs to all capital providers.

  Fix: FCFF goes with WACC and gives enterprise value. FCFE goes with Ke and gives equity value directly. Write the pairing beside your table.

• Using the pre-tax cost of debt in WACC.

  The interest rate is given in the question and is plugged in directly.

  Fix: Always multiply by (1 − t) in the WACC formula. Underline the tax rate when you read the question.

• Computing terminal value using the current year's FCFF without applying (1 + g), or discounting it by the wrong number of years.

  The Gordon formula is memorised loosely. The TV sits at the end of year N, so it must be discounted N years, not N + 1.

  Fix: Write TV = FCFF(N) × (1 + g) ÷ (WACC − g) every time, then multiply by the year-N discount factor.

• Treating depreciation as a cash outflow, or ignoring it altogether.

  Depreciation reduces EBIT, so students think it should be reduced again or dropped from the calculation.

  Fix: Depreciation is a non-cash charge. EBIT is already after depreciation, so add it back to NOPAT once. Then deduct capex separately.

• Stopping at enterprise value and calling it the value of shares.

  The DCF table ends in a large number and it looks like a final answer.

  Fix: Always do the bridge: deduct debt, preference capital and minority interest, add cash and non-operating assets, then divide by shares.

• Choosing a terminal growth rate equal to or above WACC.

  The growth rate is taken from the explicit forecast years, where it may be high.

  Fix: Use a modest long-term rate. If g is not below WACC, the formula gives a meaningless or negative value, so flag it and revisit the assumption.

Worked examples