Discounted Cash Flow: Following the Assumptions

A valuation is a set of linked assumptions

Discounted cash flow, or DCF, expresses a simple idea: the value assigned today to future cash depends on its amount, timing and risk. The calculation becomes useful when those assumptions are visible. A precise spreadsheet output does not make uncertain forecasts precise. It shows what follows if the specified inputs and model are accepted.

This example uses free cash flow to the firm, or FCFF: operating cash available to capital providers after tax and required reinvestment, before financing flows. A matching discount rate is a weighted-average cost of capital. Cash flow to equity would require a different treatment and an equity discount rate. Mixing the two can produce an internally inconsistent valuation.

A short explicit forecast cannot usually describe every future year. A terminal value summarises cash flows beyond that forecast boundary under a continuation assumption. Here a perpetual-growth formula is used, with growth below the discount rate. That convenient formula requires a sustainable operating and reinvestment story; it is not evidence that growth can continue without resources.

Change the assumption everywhere it applies

Now raise the discount rate to 11%, keeping the cash-flow forecasts and 2% perpetual growth unchanged. The terminal value must also be recalculated: £12.24 million divided by 0.11 minus 0.02 is £136 million. Discount the forecast cash flows and this revised terminal value at 11%. Enterprise value becomes approximately £126.15 million and equity value £106.15 million.

Keeping the old £153 million terminal value while changing only the discount factors would miss part of the rate assumption’s effect. The comparison is a sensitivity exercise, not a prediction that a real company’s market value will move by the same amount. Several operating and financing assumptions could change together outside the model.

The distant future can dominate the result

At 10%, the discounted terminal value contributes approximately £114.95 million of the £142.15 million enterprise value. Much of the result therefore depends on the continuation assumption. Inspecting that contribution is more informative than trusting the final decimal places. Growth, margins, reinvestment and the discount rate should form a coherent set rather than independently convenient choices.

Real bridges to equity may require adjustments for leases, pension obligations, minority interests, excess assets or other claims, depending on the valuation basis. Negative or unstable cash flows can make a simple steady-growth model inappropriate. This example has no share count and produces no per-share target. It illustrates assumptions and timing rather than identifying a fair market price.