Lesson 7 of 11 · All lessons in this module
- Present value models: DDM and FCFEVideo lesson
- Choosing the cash flow: dividends or FCFE
- FCFF, EBITDA and residual income
- Preferred stock and the Gordon growth modelVideo lesson
- Multistage dividend discount modelsVideo lesson
- Growth assumptions for any cash flow: constant, implied and two-stage
- The DCF process: discount rates, terminal values and ranges
- Integrated cases: negative growth and reconciling FCFE with FCFF
- Integrated cases: two-stage FCFF with debt, and the effect of the debt ratio
- Shortcomings of constant and multistage growth models
- Preferred shares: required return and contingency features
This lesson is part of the 2027 curriculum. You are following the 2026 curriculum, where it is not taught in this form. Switch if you are sitting the exam under the 2027 curriculum.
Lesson 7 of 11 · 14 min
The DCF process: discount rates, terminal values and ranges
A DCF valuation follows five steps: choose the cash flow, forecast it, discount it at the rate that matches whose cash it is, add a terminal value, and turn the result into a point estimate or range to compare with the price.
In short
- Five steps: cash flow measure → forecast → discount rate → terminal value → point estimate or range.
- Cash to shareholders (dividends, FCFE, RI) is discounted at ; FCFF at WACC. FCFF gives firm value: subtract the market value of debt to get equity.
- WACC ≤ ; they are equal only without debt. Discounting FCFE at WACC overstates value.
- Consistent FCFE and FCFF models should give similar equity values; a big gap means the assumptions need revisiting.
- The terminal value weighs more with a shorter horizon; its growth rate usually lies between expected inflation and nominal GDP growth, using long-run averages for the markets where the firm sells.
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