A DCF values a business as the present value of its free cash flows to the firm over a forecast period plus a terminal value, discounted at the weighted average cost of capital (WACC). The discount rate is anchored to the risk-free rate, so with the federal funds target at 3-3/4 to 4 percent after the Fed's September 2026 hike and the 10-year Treasury near 4.9% at the end of October 2026, cost-of-capital inputs are higher than many models built in lower-rate years assumed.
In this lesson you will
- Define free cash flow to the firm and explain why it is discounted at the WACC
- Calculate a terminal value with the stable-growth formula and explain its constraints
- Build a CAPM cost of equity and a WACC from current market inputs
- Describe how the Fed's September and October 2026 decisions and current Treasury yields affect discount rates
The building blocks
A firm-level DCF discounts free cash flow to the firm (FCFF) — cash flow from operations before any debt payments but after the reinvestment needed to grow — at the cost of capital, which blends the costs of debt and equity in proportion to their use [1]. The result is the value of the operating assets [1]. To get to equity value, analysts add non-operating assets such as cash and marketable securities and subtract non-equity claims, which include debt, capitalized leases, and unfunded pension and health care obligations [1].
- Start with operating income (EBIT) and subtract taxes on it.
- Add back non-cash charges such as depreciation and amortization.
- Subtract capital expenditures and increases in working capital (the reinvestment).
- The remainder is FCFF: the cash available to all capital providers.
Terminal value
Because no one can forecast year by year forever, a DCF usually forecasts explicitly until the business reaches a steady state and then captures everything after that with a terminal value [1]. The standard stable-growth formula is next year's FCFF divided by (WACC minus the perpetual growth rate) [1]. Two conditions apply: the perpetual growth rate should not exceed the growth rate of the economy, and the firm's reinvestment assumptions must be consistent with that stable growth [1]. The model is highly sensitive to the growth assumption [1].
Anchoring the discount rate: where rates stand in late 2026
Every cost of capital starts from a risk-free rate, and that rate moved in 2026. On September 16, 2026, the Federal Open Market Committee voted 12–0 to raise the target range for the federal funds rate by 1/4 percentage point to 3-3/4 to 4 percent, stating that inflation remains elevated [2]. On October 28, 2026, the Committee held the range at 3-3/4 to 4 percent by a 10–2 vote; Lisa D. Cook and Beth M. Hammack dissented in favor of another 1/4-point increase [3]. The October statement described economic activity as expanding at a strong pace and repeated that inflation remains elevated [3].
Longer-term yields, which matter more for valuation, sit well above the policy rate. The Federal Reserve's H.15 release dated November 2, 2026 shows the 10-year Treasury constant-maturity yield at 4.94% and the 30-year at 5.31% on October 30, 2026, with the effective federal funds rate at 3.88% [4]. The 10-year inflation-indexed (TIPS) yield was 2.60% that day [4]. Analysts typically match the risk-free rate to the duration of the cash flows, which is why a long-dated Treasury yield is the common choice for a going-concern DCF.
Cost of equity and the equity risk premium
The most common way to estimate the cost of equity is the capital asset pricing model: risk-free rate plus beta times the equity risk premium (ERP). Damodaran publishes a monthly implied ERP for the U.S. market; his estimate for November 1, 2026 is 4.41% on his trailing-12-month, adjusted-payout basis, up from 4.20% the prior month [5]. His page notes that this estimate uses a 5.29% U.S. Treasury rate as its risk-free input, so a careful analyst checks that the ERP and the risk-free rate used together are consistent [5].
Damodaran's broader industry datasets are refreshed annually; the most recent full update was January 9, 2026, with the next planned for early January 2027 [6]. In that January 2026 cost-of-capital table, the U.S. total market showed an average beta of 0.91, a cost of equity of 8.02%, and a cost of capital of 6.96%, while Software (Internet) showed a beta of 1.69 and a cost of capital of 10.66% [7]. Because those figures predate the September hike and the move in long yields, they are a starting point, not a current answer.
Common DCF mistakes
- Mixing nominal cash flows with a real discount rate, or vice versa.
- Using a perpetual growth rate above long-run economic growth.
- Assuming growth without the reinvestment needed to produce it.
- Discounting equity cash flows at the WACC or firm cash flows at the cost of equity.
- Updating the risk-free rate but leaving an ERP that was estimated against a different rate.
A good DCF presents a range, not a point estimate. Sensitivity tables across WACC and terminal growth show how much of the value rests on assumptions the market will keep repricing as rates move.
Key terms
- Free cash flow to the firm (FCFF)
- Cash flow from operations after taxes and reinvestment but before payments to lenders or shareholders.
- Terminal value
- The value of all cash flows beyond the explicit forecast period, often computed as next year's cash flow divided by (WACC minus perpetual growth).
- WACC
- Weighted average cost of capital: the after-tax costs of debt and equity weighted by their share of financing.
- Risk-free rate
- The return on a default-free government security, typically a Treasury yield matched to the cash-flow horizon.
- Equity risk premium (ERP)
- The extra return investors demand for holding equities over the risk-free rate.
- Beta
- A measure of how much a stock's returns move with the overall market; used in CAPM to scale the equity risk premium.
- Federal funds target range
- The FOMC's policy rate range for overnight interbank lending; 3-3/4 to 4 percent after the September 16, 2026 decision.
Check your understanding
Sources
- [1]Aswath Damodaran, NYU Stern School of Business, “Valuation Approaches and Metrics: A Survey of the Theory and Evidence,” November 2006.
- [2]Board of Governors of the Federal Reserve System, “Federal Reserve issues FOMC statement,” September 16, 2026.
- [3]Board of Governors of the Federal Reserve System, “Federal Reserve issues FOMC statement,” October 28, 2026.
- [4]Board of Governors of the Federal Reserve System, “H.15 - Selected Interest Rates (Daily) - November 02, 2026,” November 2, 2026.
- [5]Aswath Damodaran, NYU Stern School of Business, “Damodaran On-line Home Page,” Accessed November 2026.
- [6]Aswath Damodaran, NYU Stern School of Business, “Useful Data Sets,” Accessed November 2026.
- [7]Aswath Damodaran, NYU Stern School of Business, “Cost of Capital,” Data as of January 2026.
Educational content only — not legal, tax, or investment advice, or an offer to sell or a solicitation of an offer to buy any security. Rules and data are described as of November 2026 and may change. Securities offered through Umergence LLC, Member FINRA/SIPC.