The previous guide in this series built the discount rate and arrived at 9% from five sourced inputs. That solves one of the two problems in a discounted cash flow. The other is harder to get right and easier to skip: the cash flows themselves. What exactly are you forecasting, for how long, and how do you know the answer you get out is not an artefact of your own assumptions?
Start with a number this site uses everywhere. Stetron's free cash flow is $100m, its net debt is $200m, it has 50m shares trading at $37.60, the discount rate is 9% and the terminal growth rate is 4%. Almost every valuation on this site lands on $37.60 a share. Watch what that figure actually assumes.
What $37.60 assumes
Apply 4% growth to $100m for five years and then 4% in perpetuity. Discount the five years at 9%, add a terminal value of $100m × 1.04 ÷ (0.09 − 0.04) = $2,080m, discount that back five years, and the enterprise value comes to precisely $2,080m. Deduct net debt of $200m and you get $1,880m of equity. Divide by 50m shares and the answer is $37.60.
The arithmetic is exact. The assumption is not. That model never has a forecast in it -- free cash flow grows at the terminal rate in year one, in year five, and forever after. Growth is not a constant, it is a trajectory: businesses grow fast when they are small relative to their market and decelerate as they saturate it, and a business whose cash flow growth was 4% in year one has a growth rate that is already at long-run nominal GDP in the first year of the forecast.
This matters more than it sounds. The fading is where all of the real information about the business lives, and a model that skips it has quietly assumed the answer. Stetron is not a company that grows at exactly the rate of inflation indefinitely. On the numbers below, being explicit about the fade is worth about $4 a share.
The structure of the model
A five-year DCF has four parts, and it is worth naming them separately because each fails in its own way.
| Part | What it is | Where it usually goes wrong |
|---|---|---|
| Explicit forecast | Year one to year five free cash flow, built from a growth path | Growth is extended past the point where the business can sustain it |
| Terminal value | A single number representing everything after year five | Perpetual growth set above the growth rate of the economy |
| Discounting | Converting future cash to present value at the WACC | The rate is a habit rather than a build |
| The bridge | Enterprise value → equity value → per-share value | Net debt, minorities and dilution quietly omitted |
The explicit forecast is the part people argue about, and it is the part that matters least. On Stetron's numbers the five discounted years are worth $469m. The terminal value is worth $1,808m. Roughly four-fifths of the answer arrives before the spreadsheet touches a single forecast year.
That is not a flaw in the method. It is arithmetic: a going concern generates most of its cash after the forecast window, so the window itself was never going to hold the answer. It does mean that effort spent arguing about year three is effort spent on 20% of the result.
A fade, worked end to end
Give Stetron a growth path that fades linearly from 8% to the terminal 4%: 8%, 7%, 6%, 5%, 4%. Each year's cash flow is the previous year's grown at that rate, and each is discounted back at 9%.
| Year | Growth | Free cash flow | Discount factor at 9% | Present value | |
|---|---|---|---|---|---|
| 1 | 8% | $108.00m | 0.9174 | $99.08m | |
| 2 | 7% | $115.56m | 0.8417 | $97.26m | |
| 3 | 6% | $122.49m | 0.7722 | $94.59m | |
| 4 | 5% | $128.62m | 0.7084 | $91.12m | |
| 5 | 4% | $133.76m | 0.6499 | $86.94m | |
| Sum of discounted forecast cash | $468.99m | ||||
| Terminal value = $133.76m × 1.04 ÷ (0.09 − 0.04) | $2,782.27m | ||||
| Discounted terminal value = $2,782.27m × 0.6499 | $1,808.29m | ||||
| Enterprise value | $2,277.27m | ||||
| Less net debt | −$200.00m | ||||
| Equity value | $2,077.27m | ||||
| Per share on 50m shares | $41.55 | ||||
Same discount rate, same terminal growth, same balance sheet. The only thing that changed is that the forecast now contains a business instead of a straight line. Fair value went from $37.60 to $41.55 — and, against a $37.60 market price, from "fairly valued" to "10% undervalued". A change in conclusion from a change in method rather than in fact is exactly the failure this section exists to prevent.
The check almost nobody runs
Take the terminal value and divide it by something comparable that sits in the same year. This is called an implied exit multiple, and it is the fastest way to catch a terminal assumption that has quietly drifted.
Stetron's terminal value of $2,782m divided by year-five free cash flow of $133.76m is 20.8×. Read as a multiple, that says the market at the end of year five pays 20.8× cash for this business forever. Stetron's EBITDA grows from $366m to $489.57m over the same path, and $2,782m ÷ $489.57m = 5.68× EV/EBITDA.
Compare that with what you pay today: at $37.60 the enterprise value is $2,080m, which is 5.68× today's EBITDA of $366m. The implied exit multiple is identical — which is a clean result and a useful sanity check. The fade changed the answer because it assumed the business earns a bit more cash by year five, not because it quietly assumed Stetron is worth 20× cash at some distant date. If your implied exit multiple comes out at 35×, or at 4× with no explanation, your terminal assumption is doing something you did not intend. Recalculate before you believe the headline.
Three growth paths, three answers
The point of a scenario is not to produce a range you can average. It is to show which of your assumptions the answer actually depends on.
| Scenario | Growth path | Year 5 FCF | Terminal value | Value per share | vs $37.60 |
|---|---|---|---|---|---|
| Strong fade | 12% → 10% → 8% → 6% → 4% | $146.68m | $3,050.96m | $45.75 | +21.7% |
| Base fade | 8% → 7% → 6% → 5% → 4% | $133.76m | $2,782.27m | $41.55 | +10.5% |
| Slow start | 2% → 2% → 3% → 4% → 4% | $115.91m | $2,410.84m | $35.70 | −5.1% |
Two observations. First, the terminal value share barely moves — 78.9%, 79.4% and 79.7% of enterprise value across the three — so the model's reliance on the terminal assumption is structural, not a consequence of any one path you picked. Second, the full spread from slowest to fastest is $10 a share, or 28% of the base case, and every dollar of it comes from assumptions about the first five years. That is unusual: normally the near years are the part you feel you know least about.
The slow-start case is the most instructive, because it is the one that fails. It assumes Stetron barely grows for two years. At $35.70 against a $37.60 price, the stock looks marginally expensive, and the honest conclusion is that you do not know enough to buy it. A scenario that changes only the growth rate should be able to flip a conclusion, or the model is not doing any work.
The two inputs that dominate
Fix the base fade path and vary the discount rate against the terminal growth rate. Value per share:
| WACC \ terminal g | 3.0% | 3.5% | 4.0% | 4.5% | 5.0% |
|---|---|---|---|---|---|
| 8.0% | $43.14 | $47.51 | $52.98 | $60.00 | $69.36 |
| 8.5% | $38.83 | $42.34 | $46.63 | $51.99 | $58.88 |
| 9.0% | $35.23 | $38.10 | $41.55 | $45.76 | $51.02 |
| 9.5% | $32.18 | $34.57 | $37.39 | $40.77 | $44.91 |
| 10.0% | $29.57 | $31.58 | $33.93 | $36.69 | $40.02 |
| 11.0% | $25.34 | $26.80 | $28.48 | $30.42 | $32.68 |
Two features of this grid are worth more than the numbers in it. The spread across the discount rate alone, from 8% to 10%, is $19 a share — wider than the entire growth-scenario range. And the grid curves away violently in the top-right corner: at an 8% discount rate with 5% perpetual growth, Stetron is worth $69, because a 3-point spread between r and g is being divided by three. Perpetual growth is only meaningful when it is comfortably below the discount rate, and the closer the two get, the less your answer has to do with the business.
This is also why the terminal growth rate cannot exceed long-run nominal GDP growth, roughly 2–3% in developed markets. A company cannot grow faster than its economy forever, and one that appears to is usually a company whose forecast period is too short rather than one with exceptional economics.
Four ways a DCF misleads
Flattening the forecast. The $37.60 result on this site is the clearest example: growth of 4% in every year means no forecast at all. If your first-year growth rate equals your terminal rate, you have not forecast anything — you have assumed the answer and then computed a discount factor.
Omitting the bridge. Enterprise value is the value of the operations, before any claim on them. Net debt of $200m comes off first, then minority interests at market value, and then dilution from options and unvested stock. A share count that ignores unvested equity produces a per-share figure that is quietly optimistic, because the cash being valued is being divided among fewer shares than the company really has outstanding.
Terminal growth set from ambition. Setting g equal to the growth rate of the industry the business operates in, rather than of the economy it operates within. A company can out-grow its industry for a while; it cannot out-grow nominal GDP forever.
Treating one number as the answer. The honest output of a DCF is a range with an argument attached. $41.55 on a base fade is a central case, not a valuation. What makes it usable is that you can now say which assumption you would have to be wrong about to justify the current price — and the reverse DCF inverts the question to ask precisely that.
Running your own
Build the discount rate properly in the WACC calculator first, then carry it into the DCF calculator and vary the growth inputs rather than typing one number and stopping. Change the first-year growth rate and leave the terminal rate alone to see how much of the fade is doing the work. Then set the first-year rate equal to the terminal rate: if the answer lands exactly on the flat-perpetuity value, the model is behaving correctly and you know the forecast contributed precisely the difference you expected.
Once you have a number you believe, the last step is not another DCF. It is deciding how much discount that number deserves before you buy it, which is what margin of safety is for — and the reason a $41.55 estimate and a $37.60 price is not yet a trade.
Related guides
- Free Cash Flow: What It Is and Why It Matters — The input every valuation depends on, including a case where profit is positive and cash flow is not
- How to Read a Cash Flow Statement — The three sections, the eight sign combinations, and what each one warns you about
- How to Read a Balance Sheet — Reading the asset side properly: six ratios, the ROE decomposition, and four common traps
More guides
- Dividend Investing — Testing whether a dividend is actually safe, using payout, cash coverage and leverage
- Intrinsic Value vs Market Price — Why the two diverge, when cheap is not cheap, and what should force your estimate downward
- What Is a Good P/E Ratio? — The arithmetic of a justified multiple, and the four ways a low P/E ratio lies to you
- Dividend Yield vs Total Return — Four ten-year scenarios showing why a high yield and a high return are different things
- How to Compare Two Stocks — A five-axis comparison, worked side by side, and why the cheaper multiple can be the dearer stock
- WACC Explained — The discount rate built from five sourced inputs, on the same worked example
- The Graham Number Explained — Graham's ceiling tested on two companies, and the three things it cannot see
- How to Value a Stock — The full valuation sequence on one worked example, from choosing a method to setting a buy price
- Margin of Safety — How big a discount a given business deserves, and why a low multiple is not the same as a discount
Free valuation calculators
- DCF Calculator — fair value from five years of cash flow plus terminal value
- Dividend Discount Model — Gordon Growth valuation for dividend payers
- CAGR Calculator — compound growth rate and forward projections
- Dividend Yield Calculator — yield, income per $10,000, capital needed
- Payout Ratio Calculator — dividend safety and sustainable growth
- P/E Ratio Calculator — multiple, earnings yield, PEG, target price
- Graham Number Calculator — Graham's maximum buy price
- Total Return Calculator — price change plus dividends, annualized
- EV/EBITDA Calculator — enterprise value against operating earnings
- WACC Calculator — weighted average cost of capital for discounting
- Two-Stage DDM Calculator — high-growth then stable dividend valuation
- EPS Calculator — basic and diluted earnings per share
- P/B Ratio Calculator — price against book value, with ROE context
- Margin of Safety Calculator — discount between value and price
- Compound Interest Calculator — future value with periodic contributions
- Reverse DCF Calculator — the growth rate today's price already assumes
- DuPont ROE Calculator — break return on equity into its three drivers
- Position Size Calculator — how many shares to buy for a set risk