What is free cash flow?

Free cash flow, or FCF, is the cash flow remaining after the company has paid its operating costs and necessary investments. It is typically calculated as operating profit minus tax, minus changes in working capital, minus capital expenditure. It is the money the company can genuinely use freely.

What discount rate should I use?

There is no universal number. Common starting points are WACC, weighted average cost of capital, or a simple required return based on the risk-free rate plus a risk premium. Many practitioners use eight to twelve per cent as a practical range for Swedish companies. The important thing is that the rate reflects the risk of the specific company.

How do you set the long-term growth rate?

The terminal value assumes the company grows forever at a constant rate. The long-term growth rate should never exceed long-term GDP growth - otherwise you are assuming the company eventually dominates the entire economy. It is typically set at two to three per cent.

Why are DCF models rarely precise?

Cash flow forecasts over five to ten years carry large uncertainties. The terminal value, which typically accounts for the majority of fair value, is extremely sensitive to assumptions about growth and the discount rate. DCF is a framework for structured thinking, not a precision instrument. Two analysts with slightly different assumptions can arrive at very different values.

Glossary

DCF

Discounted Cash Flow. A valuation method that calculates what a company's future cash flows are worth today. The core principle: a unit of money tomorrow is worth less than a unit of money today.

What it is

Future cash flows, discounted to today

DCF is a method for estimating what a company should be worth today, based on the cash flows it is expected to generate in the future. Each future cash flow is discounted back to present value using a discount rate that reflects risk and opportunity cost. The sum of all discounted cash flows, including a terminal value for everything beyond the forecast period, gives an estimate of the company's fair value.

The discount rate: The discount rate reflects the return you require from the investment. Higher risk demands a higher discount rate, which lowers the present value of future cash flows. A one percentage point difference in the discount rate can change the fair value estimate by 20 to 30 per cent.
The terminal value: In most DCF models, the terminal value accounts for 60 to 80 per cent of total fair value. It is calculated from an assumption about perpetual growth and is derived from the last year's cash flow in the forecast period. That makes the long-term growth rate the most sensitive variable in the entire model.
Quality of the cash flow: DCF is only as good as its inputs. The free cash flow used should be normalised, not a single unusually high or low year. Forecasts over five to ten years carry large uncertainties. The longer the forecast period, the more speculative the model.

How it is used

A tool for making assumptions explicit

DCF is used in practice to work backwards: given a current share price, what growth and profitability is the market assuming? That question can be more illuminating than building a forward-looking forecast. If the market is pricing in ten per cent growth over ten years and the company has historically grown at five per cent, that tells you something. DCF is a model, not a truth. The value of the model is that it forces you to articulate your assumptions and see what they imply.

“We do not marry our view of the company. That is how we know when to divorce it.”

Amos Fonder

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Common questions about DCF

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ROIC

The single metric that best measures whether a company is genuinely creating value with its capital — or merely cycling through it.

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The difference between a company's intrinsic value and its market price. The foundation of thinking about risk and asymmetric return.

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