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Free Cash Flow and DCF Valuation

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Cost of Equity and CAPM ApplicationFinancial Statement Analysis for Valuation+3 moreEnterprise Value and Valuation Multiples
equity-valuation dcf cash-flow

Core Idea

Free cash flow (FCF) is cash available after capital expenditures and working capital changes. DCF valuation projects future FCF and discounts at the cost of equity to find intrinsic value, providing a theoretically rigorous equity valuation method.

How It's Best Learned

Start with a simple 5-year projection and terminal value using a constant growth model. Compare FCF-based values to market prices to identify mispricing.

Common Misconceptions

Explainer

From present value and discounting, you know that a dollar received in the future is worth less than a dollar today, and the further away it is, the steeper the discount. From CAPM, you know how to estimate the cost of equity — the rate of return shareholders require given the riskiness of the stock. DCF valuation is the application of these ideas to equity: the intrinsic value of a stock is the present value of all future cash flows it will generate, discounted at the appropriate risk-adjusted rate.

The first and most important distinction is between free cash flow and accounting earnings. Net income includes non-cash charges (like depreciation) and excludes real cash outflows (like capital expenditures). A company that reports $100M in net income but needs to spend $80M on new equipment and $20M on working capital to sustain its growth has generated nothing for shareholders — it has no free cash flow. Free cash flow strips away accounting artifacts and asks: after maintaining and growing the business, how much actual cash is left? FCF = Net Income + Depreciation − Capital Expenditures − Increase in Working Capital. Sometimes it is calculated from operating cash flow (starting from EBITDA or EBIT after taxes) rather than from net income, but the concept is the same: residual cash available to equity holders after all reinvestment needs are met.

A DCF model takes three inputs: (1) projected FCF for a forecast period (typically 5–10 years), (2) a terminal value representing all cash flows after the forecast period, and (3) the discount rate (cost of equity from CAPM, or WACC if valuing the whole firm). The terminal value is usually estimated using the Gordon Growth Model: TV = FCF_(n+1) / (r − g), where g is the long-run sustainable growth rate. Each year's FCF is then discounted back to today and summed with the discounted terminal value to produce intrinsic value per share.

The unsettling implication is how sensitive the result is to assumptions. A small change in the terminal growth rate g from 3% to 4%, or in the discount rate r from 9% to 8%, can change the valuation by 20–40%. This is not a bug but a feature: it tells you that most of a growing company's value lies in its terminal value — the cash flows beyond the forecast horizon — and small changes in long-run assumptions matter enormously. The discipline of DCF is less about computing a precise number and more about making your assumptions explicit and stress-testing them. A "sensitivity table" showing valuations across a matrix of r and g values is standard practice precisely because no one has high confidence in a single set of inputs.

Practice Questions 5 questions

Prerequisite Chain

Understanding ZeroThe Number ZeroCounting to FiveCounting to 10Counting to 20Counting a Set of Objects Up to 20Cardinality: The Last Number CountedMatching Numerals to QuantitiesSubitizing Small QuantitiesAddition Within 10Number Bonds to 10Addition Within 20Doubles and Near DoublesDoubles Facts Within 10Near Doubles Facts Within 20Mental Math Strategies for AdditionMental Math: Adding and Subtracting TensAddition Within 100Repeated Addition as MultiplicationMultiplication as Equal GroupsMultiplication: ArraysBasic Multiplication Facts (0s, 1s, 2s, 5s, 10s)Multiplication Facts Within 100Division as Equal SharingDivision as Grouping (Measurement Division)Division: Grouping (Repeated Subtraction) ModelDivision: Fair Sharing ModelDivision as Equal SharingDivision as GroupingBasic Division FactsDivision Facts Within 100Multiplication and Division Fact FamiliesRelationship Between Multiplication and DivisionDivision Facts as Inverse of MultiplicationRemainders and Quotients in DivisionDivision Word ProblemsMulti-Step Word ProblemsSolving Multi-Step Word ProblemsMultiplication Word ProblemsDivision Word ProblemsIntroduction to Long DivisionFactors and MultiplesPrime and Composite NumbersEquivalent FractionsRelating Fractions and DecimalsDecimal Place ValueIntegers and the Number LineComparing and Ordering IntegersAbsolute ValueAdding IntegersSubtracting IntegersMultiplying IntegersDividing IntegersUnit RatesProportionsPercent ConceptConverting Between Fractions, Decimals, and PercentsOperations with Rational NumbersTwo-Step EquationsSolving Multi-Step EquationsEquations with Variables on Both SidesAngle Pairs: Complementary, Supplementary, and VerticalParallel Lines and TransversalsCorresponding AnglesAlternate Interior AnglesTriangle Angle Sum TheoremExterior Angle TheoremTriangle Inequality TheoremSimilar Triangles: AA SimilaritySimilar Triangles: SSS and SAS SimilarityProportions in Similar TrianglesRight Triangle Trigonometry IntroductionSine, Cosine, and Tangent RatiosTrigonometric Ratios ReviewRadian MeasureConverting Between Degrees and RadiansThe Unit CircleGraphing Sine and CosineGraphing Tangent and Reciprocal Trigonometric FunctionsDerivatives of Trigonometric FunctionsAntiderivativesIndefinite IntegralsBasic Integration RulesRiemann SumsDefinite Integral DefinitionDouble Integrals: Definition and SetupIterated Integrals and Fubini's TheoremDouble Integrals over Rectangular RegionsDouble Integrals over General RegionsApplications of Double Integrals: Area, Mass, and MomentsCenter of MassConservation of Linear MomentumElastic CollisionsInelastic CollisionsCoefficient of RestitutionCollision Analysis and Real-World ApplicationsTwo-Body Collisions in the Center-of-Mass FrameReduced Mass and Two-Body ProblemsKinematics in Two DimensionsProjectile MotionCircular Motion: KinematicsSimple Harmonic MotionIntroduction to Differential EquationsSolow Growth ModelCapital Accumulation and the Golden RuleInvestment Demand and Capital FormationAggregate DemandThe AS-AD ModelBusiness CyclesMonetary Policy ToolsTerm Structure of Interest RatesRisk and Return TradeoffExpected Return and Variance of Financial AssetsPortfolio DiversificationMean-Variance Optimization (Markowitz Framework)Efficient Frontier and Capital Market LineCapital Asset Pricing Model (CAPM)Cost of Equity and CAPM ApplicationWeighted Average Cost of Capital (WACC)Free Cash Flow and DCF Valuation

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