The earnings for each of the future accounting period are estimated based on the past performance of the firm as well as growth opportunities available for additional income. Each of the future earnings is then discounted at an appropriate discount rate, which is equal to the cost of capital required for the operation of the firm, to determine the present value. Also, a terminal value is calculated once the firm achieves a stable growth rate. This terminal value is then discounted at the rate of cost of capital to calculate its present value. All the present values thus calculated so far are then added to determine the cumulative value of the firm.
An elementary equation of the valuation of a firm is –
There are three different ways of valuing under Discounted Future Earnings Method.