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Discounted cash flow

Discounted cash flow, or DCF, values an asset as the present value of the cash it is expected to produce, each amount reduced by a discount rate for the wait and the risk.

A two-stage DCF does not forecast forever by hand. It forecasts a stretch of explicit years, then assumes growth settles at a long-run rate and capitalises that remainder as a perpetuity. Enterprise value is the present value of both pieces. Most of the value usually sits in the terminal stage, which is why a small change in perpetual growth moves the answer more than a tweak to year one. The explicit years earn their keep by setting the level the perpetuity takes off from, not by being most of the value.

The standard form is V=t=1nFt(1+r)t+Fn(1+g)(rg)(1+r)nV = \sum_{t=1}^{n} \frac{F_t}{(1+r)^t} + \frac{F_n(1+g)}{(r-g)(1+r)^n}, where FtF_t is free cash flow in year tt, rr the discount rate and gg perpetual growth after the explicit stage. Terminal growth has to stay below the discount rate: Gordon growth divides by rgr - g, so if gg meets or exceeds rr the perpetuity has no finite value. The DCF calculator is the two-stage identity with that bound enforced.

Enterprise value is the value of the operations, before subtracting net debt. Equity value is a further step. The discount rate is usually WACC, which is the job of the WACC calculator. Mixing a real WACC with nominal cash flows, or using the high explicit-stage growth rate as gg forever, is how a DCF explodes. For a finite series with no terminal value, net present value is the right tool.

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