Discounted Cash Flow (DCF)

The general-purpose stock valuation tool

DDM works for dividend-payers. Discounted Cash Flow (DCF) generalizes the idea to any company by using free cash flow instead of dividends. From last track: FCF is the cash actually available to investors after operating costs and necessary reinvestment. Dividends are one way to distribute FCF, but a company has options — buybacks, debt paydown, reinvestment, or just hoarding cash.

So we value a stock as the present value of all its future free cash flows:

That looks scary, but it's literally the integral lesson from Track 1 made discrete. Each future year's FCF, discounted to today, summed up. Area under the curve, expressed as a sum.

The two-stage DCF — what real practitioners use

Forecasting infinite future is impossible. So real DCFs split into two pieces:

1. Explicit forecast period (typically 5-10 years): an analyst projects FCF year-by-year. These are the explicit numbers you'll see in research reports.
2. Terminal value (everything after): assume FCF settles to a long-run growth rate g and apply Gordon Growth.

Math:

The first sum is the explicit period. The second piece is the terminal value (Gordon Growth on the cash flow at year N+1) discounted back to today.

Critically: terminal value is usually 60-80% of total DCF value. So your assumption about long-run g matters more than the explicit-period forecasts. This is also why DCF is often called "garbage in, garbage out" — small changes to g or r swing the answer hugely.

Choosing r — the discount rate

The r in DCF should reflect the risk of the cash flows. For unlevered (firm-level) DCF, the standard choice is the weighted average cost of capital (WACC) — a blend of the cost of debt and cost of equity, weighted by their proportions. We won't compute WACC here; just know it's the standard discount rate for full-firm DCF.

For equity-only DCF (using FCFE), use the cost of equity directly — typically computed via CAPM (Track 9): r = r_f + β × equity risk premium. Lesson 6-3 onward will mostly use simplified r; precise WACC computation is a corporate-finance topic for later.

What can move the DCF result

Same three drivers we've seen all quest:

• FCF projections higher → P higher
• Discount rate r lower → P higher
• Terminal growth rate g higher → terminal value higher → P higher

The 2022 stock crash was largely DCF math: rising r_f (Fed hikes) increased the discount rate; recession fears reduced FCF projections; growth expectations g dimmed. All three pushing P down at once. Tracks 4 and 7 already mentioned this; here's the equity-side mechanism.

The takeaway

DCF generalizes DDM. Value = sum of future FCFs, each discounted to today. Real DCFs use two stages: explicit forecast + terminal value. Terminal value is usually most of the answer, so long-run g assumption is critical. Three drivers (FCF, r, g) — same picture. Lesson 6-3 covers a totally different (lighter) approach: multiples.