The moving parts
- Forecast free cash flow: for a firm-level model, the cash available to all capital providers after operating costs, tax, capital spending and investment in working capital.
- Discount rate: the WACC for firm-level flows, or the cost of equity when the model works with free cash flow to equity instead.
- Terminal value: everything after the explicit forecast, usually a growing perpetuity or an exit multiple.
- Bridge to equity: deduct debt and other non-equity claims from firm value, then divide by the shares outstanding.
CFA Institute's free cash flow valuation reading treats a security's intrinsic worth as today's value of the cash it is expected to produce, and sets out two routes to the equity. One values the firm by discounting free cash flow to the firm at the blended cost of all capital and then subtracts debt; the other values equity directly from free cash flow to equity at the shareholders' required return. The discipline that matters is consistency. Firm-level flows go with a firm-level rate, nominal flows with a nominal rate, and the growth rate in the terminal value has to be one the business could sustain indefinitely, which rules out anything faster than the economy it operates in.
Where models go wrong
The ways it goes wrong are predictable. Forecasts extend recent growth without asking what limits it; the terminal value is built from a final year that still carries unusual capital spending; the rate is tuned until the model reaches a price someone already had in mind. A DCF belongs beside comparable companies and precedent transactions in corporate finance and valuation as one view among several, and its advantage is that every assumption is written down where it can be challenged. Mechanically it is net present value without the initial outlay, resting on the time value of money.