Which inputs are typically projected in a basic discounted cash flow model to estimate value?

• A. Revenue growth and margins only
• B. Earnings before interest and taxes (EBIT) only
• C. Free cash flow to the firm (FCFF) or free cash flow to equity (FCFE)
• D. Net income only

Answer: (C)

Discounted cash flow valuation focuses on cash generation rather than accounting profits. In a basic model you forecast cash flows that are actually available to investors, namely Free Cash Flow to the Firm (FCFF) or Free Cash Flow to Equity (FCFE). FCFF represents the cash a company generates after operating expenses, taxes, and reinvestment needs, available to both debt and equity holders. FCFE represents the cash remaining after interest and debt payments, available to equity holders. These cash flows are then discounted to present value to estimate enterprise value (FCFF) or equity value (FCFE).

Revenue growth and margins are important inputs used to derive those cash flows, but they are not the cash flows themselves. EBIT is an operating profit measure that doesn’t reflect cash after taxes and reinvestment, and net income is an accrual-based figure that doesn’t equal actual cash flow.