Pairing rules
| Cash flow | Discount rate | Output |
|---|---|---|
| FCFF | WACC | Enterprise value (subtract net debt for equity) |
| FCFE | Cost of equity | Equity value directly |
| Dividends | Cost of equity | Equity value (only for stable payers) |
Terminal value
The two conventional approaches: Gordon growth (terminal FCF × (1 + g) / (r - g)) and exit multiple (terminal FCF × assumed multiple). Sense-check the implied multiple on Gordon, and the implied growth on multiple-method. Terminal value is typically 60-80% of total DCF value; small assumption changes move the answer materially. CFA refresher readings[CFA Inst]treat both methods in detail.
Terminal growth rate
Cap at long-run nominal GDP for the operating geography (roughly 3-4% for developed markets in 2026 expectations). Anything above signals an embedded assumption that the firm grows faster than the economy forever.
When DCF is the wrong tool
- Banks: use dividend discount or residual income.
- REITs: use AFFO-based valuation.
- Pre-revenue biotechs: use scenario / probability-weighted milestone models.
- Cyclicals at peak earnings: normalise revenue or step down to mid-cycle FCF.