2.2.4 · 40–60 minutes · read, calculate, discuss, review
What you will learn
- Calculate present value and distinguish it from NPV.
- Explain a DCF workflow.
- Match a cash-flow claim with its discount rate.
2.2 · Valuation
Valuation
Valuation · the work you will do
- 1Define the cash flow
- 2Make assumptions explicit
- 3Estimate a range
- 4Compare with price
Before you begin
Would £110 promised in one year be worth £110 today? What would you need to know about timing, alternatives and risk?
Write your first response before continuing.
Video coming soon · about 3 minutes
Discounted Cash Flow: Part 1
Use the narration below while the recording is being made, then try the decisions in this lesson.
Read the full narration
Welcome to On Judgement. Would £110 promised in one year be worth £110 today? What would you need to know about timing, alternatives and risk? Take a first view. You can change it when you have considered the evidence.
Present value translates a future cash amount into an equivalent today using a stated required return. For an end-of-year flow, PV = cash flow/(1+r)^t. The discount rate must fit the currency, risk and cash-flow convention. More distant payments are discounted more under a positive rate. This is a model of trade-offs, not proof a promised payment will occur.
A company must pay for inventory, customers’ credit and equipment as well as recognise profit. Free cash flow to the firm is available before financing distributions, after the operating investment assumed in the model. Its enterprise valuation uses an appropriate weighted cost of capital. Equity cash flow uses an equity discount rate. Swapping these rates and claims can create a precise-looking but inconsistent result.
Understand the business and forecast operating drivers. Convert the forecast into the relevant cash flows. Establish a consistent discount rate. Discount explicit-year flows. Estimate and discount a value for later years when appropriate. Bridge operating value to the shareholder claim and divide by shares. Finally test assumptions and compare with price. A model can include early negative cash flow; that makes financing and later expectations especially important.
A company’s enterprise present value is not automatically an investment project’s NPV. A project NPV subtracts the initial outlay from discounted future net cash flows on a consistent basis. Payback, ARR and NPV ask different questions. This company-valuation work is investing enrichment; it connects to AQA’s appraisal and evaluation skills without replacing the specification’s defined techniques.
Let's work through Two-year project appraisal. An isolated project costs £100 today and is assumed to pay £60 at the end of each of years 1 and 2, with no other cash flows. Use a 10% discount rate. Pause here and try the calculation or reasoning before continuing.
PV year 1 = 60/1.10 = £54.55, rounded. PV year 2 = 60/(1.10²) = £49.59, rounded. PV of receipts = £104.13 using unrounded calculations. NPV = 104.13 − 100 = £4.13, approximately.
A positive NPV is conditional on these cash flows and the appropriate rate. Capacity, implementation risk and alternative uses of capital remain relevant.
Now try the choices in this lesson. If your answer changes, identify the reason. Match a cash-flow claim with its discount rate. Use the case activities to put the idea into your own words, and return to the evidence when more than one conclusion is defensible.
Time has an opportunity cost
Present value translates a future cash amount into an equivalent today using a stated required return. For an end-of-year flow, PV = cash flow/(1+r)^t. The discount rate must fit the currency, risk and cash-flow convention. More distant payments are discounted more under a positive rate. This is a model of trade-offs, not proof a promised payment will occur.
Cash flows, not just earnings
A company must pay for inventory, customers’ credit and equipment as well as recognise profit. Free cash flow to the firm is available before financing distributions, after the operating investment assumed in the model. Its enterprise valuation uses an appropriate weighted cost of capital. Equity cash flow uses an equity discount rate. Swapping these rates and claims can create a precise-looking but inconsistent result.
The workflow
Understand the business and forecast operating drivers. Convert the forecast into the relevant cash flows. Establish a consistent discount rate. Discount explicit-year flows. Estimate and discount a value for later years when appropriate. Bridge operating value to the shareholder claim and divide by shares. Finally test assumptions and compare with price. A model can include early negative cash flow; that makes financing and later expectations especially important.
Value and investment appraisal
A company’s enterprise present value is not automatically an investment project’s NPV. A project NPV subtracts the initial outlay from discounted future net cash flows on a consistent basis. Payback, ARR and NPV ask different questions. This company-valuation work is investing enrichment; it connects to AQA’s appraisal and evaluation skills without replacing the specification’s defined techniques.
Two-year project appraisal
Cash later is worth less today
Why is the second £60 receipt discounted more heavily?
An isolated project costs £100 today and is assumed to pay £60 at the end of each of years 1 and 2, with no other cash flows. Use a 10% discount rate.
- PV year 1 = 60/1.10 = £54.55, rounded.
- PV year 2 = 60/(1.10²) = £49.59, rounded.
- PV of receipts = £104.13 using unrounded calculations.
- NPV = 104.13 − 100 = £4.13, approximately.
A positive NPV is conditional on these cash flows and the appropriate rate. Capacity, implementation risk and alternative uses of capital remain relevant.
Put it into practice
1. Explain the rate
£110 is expected at the end of year 1. Calculate PV at 10%, then at 20%.
Record your response in your workbook before opening feedback.
Compare with a model response
PV is £100 at 10% and £91.67 at 20%. A higher required return reduces present value, all else equal.
2. Match the claim
Explain why discounting cash after interest at WACC can be inconsistent.
Record your response in your workbook before opening feedback.
Compare with a model response
WACC is used here for unlevered operating cash available across capital providers. After-interest equity cash needs a consistent equity framework; mixing claims can double-count financing effects.
3. Order the process
Write the DCF workflow in your own words, identifying a check at each stage.
Record your response in your workbook before opening feedback.
Compare with a model response
Check business drivers, cash-flow bridge, rate consistency, timing, terminal assumptions, claim adjustments, share count and sensitivities. There is no magic value produced independently of these choices.
Jargon buster
Present value
A future amount discounted to a stated date.
Discount rate
The return used to translate the relevant cash-flow claim across time.
NPV
Discounted future net cash flows less the initial investment on a stated basis.
FCFF
Free cash flow to the firm before financing distributions.
WACC
Weighted average cost of capital under stated capital and tax assumptions.
Explicit forecast
The individually forecast period before a terminal assumption.
Knowledge check
Make each choice on the page. Feedback explains the reasoning. Use Try again after revisiting an idea.
AQA connection and further reading
AQA 7138 connections: 3.1.4 financial management, 3.3.3 strategy/investment appraisal, 3.3.4 change and uncertainty; Annex 6 quantitative interpretation; AO2–AO4 application, analysis and evaluation. Enterprise DCF, WACC, trading multiples and SOTP are investing enrichment, not prescribed AQA company-valuation methods.
AQA 7138 specification
Primary curriculum mapping; teacher interpretation, not endorsement.
IAS 7 overview · IFRS Foundation
Accounting classification context. Presentation changes and effective/adoption dates must be checked for real reports.
Free Cash Flow Valuation · CFA Institute
Technical cross-check for consistent claims and valuation formulas; advanced optional reading.
Introduction to Valuation · Aswath Damodaran, NYU
Optional deeper reading on valuation approaches.
Take forward
Calculate present value and distinguish it from NPV. Explain a DCF workflow. Match a cash-flow claim with its discount rate.