DCF
Factual definition
Discounted cash flow (DCF) is a method for calculating the present value of expected future cash flows using a discount rate consistent with their risk and the claim being valued.
Also called Discounted cash flow
Forecast cash flows and terminal value
Hypothetical: project five annual periods of free cash flow to the firm and a terminal value at the end of year five. Discount both the annual flows and that terminal value to the valuation date using a consistent weighted average cost of capital to estimate enterprise value.
The four steps
- project cash flows on a consistent claim basis
- choose the matching discount rate
- estimate terminal value at forecast end
- discount the flows and terminal value to today
How Shayne Fitz-Coy uses DCF
When do we do a DCF? And I will tell you practically never.
Discount the terminal value as well as the forecast years
Hypothetical valuation at 1 January 2025, US$ millions: forecast FCFF of 10, 11 and 12 paid exactly one, two and three years later. These are after operating taxes and reinvestment but before financing flows.
Assume a matching 10% annual WACC and sustainable 2% growth from year four onward. Year-four FCFF is 12.24, so terminal value at the end of year three is 12.24 ÷ (10% − 2%) = 153.
Operating-business value today is 10 ÷ 1.10 + 11 ÷ 1.10² + (12 + 153) ÷ 1.10³ = 142.15. If debt is 40, surplus cash is 5 and no other claims or adjustments apply, equity value is 107.15.
The terminal component contributes 114.95, about 80.9% of operating value. Most of this result therefore depends on cash expected after the explicit forecast, not merely the first three years.
The CFA free-cash-flow framework uses this matching of cash flows, discount rates and terminal timing. Test the long-run reinvestment and growth assumptions before relying on the result; EBITDA is not a substitute for the FCFF amounts assumed here.