Free Cash Flow, Terminal Value, and Discount Rates and Methods

This chapter illustrates the theory and technical implementation of deriving a corporate value, using an intrinsic, cash flow–based approach. In this approach, cash flow is projected and then discounted back to the present day to determine the present value. This is similar to the valuation of many financial instruments, where cash flow is projected and then discounted back to the present day to determine the present value. The discounted cash flow (DCF) methodology can be applied to securities pricing, project valuation, and nearly any other investment opportunity valuation. The challenge of using a DCF methodology for corporations is determining what constitutes cash flow and what discount rate(s) to use to determine the present value. The number of periods of cash flow one counts in a forecast is also of major concern. Many company owners would suggest that their company is worth more than just the cash flows that can be spun out of the firm during the forecast period. There is a terminal value to a firm since the firm could be liquidated after the forecast period. After understanding the what cash flow counts and for how long, ne then need figure out the proper rate or rates to discount the cash flows to obtain a present value.