Whether or not a stock is “actually worth” its market price comes down to all sorts of factors. To evaluate those factors and try to answer the question of worth, investors use a variety of valuation models. Discounted cash flow (DCF) analysis is one of them.
It sounds complex, but it’s really just a way of deciphering how much the company behind the stock will make in the future, and what that future money is worth today.
DCF helps investors evaluate a company’s intrinsic value, meaning what it’s worth based on its ability to generate money over the long term and not what the market says it’s worth at any given moment based on supply, demand, hype, or fear.
If you’re a self-directed investor, knowing how to apply DCF to value stocks can be essential.
What DCF analysis does (and why it matters)
DCF analysis helps you compare “what a company is worth” vs. “what the market is pricing it at.” That’s important because it lets you see beyond market hype, fear, or news headlines and focus on where the business is headed.
Instead of relying on recent earnings or stock trends, DCF uses a company’s business fundamentals to estimate how much its future cash flows are worth in today’s dollars. To understand why DCF works, it’s helpful to know two key concepts: the time value of money (TVM) and present value (PV).
TVM is the idea that a dollar today is worth more than a dollar in the future because of its potential earning capacity. In other words, the dollar today can be invested to earn a return or to avoid the effects of inflation on its value. DCF applies this principle by discounting future cash flows to account for the fact that future dollars are worth less than dollars today.
PV is the method of calculating what that future amount is worth today. It’s the key building block of DCF analysis: the DCF method adds up the present values of many future cash flows to determine the value of an investment today.
DCF analysis doesn’t make sense for every company you might consider for investment. If a company is fairly young and doesn’t have a track record, then DCF can be more of a guess than an analysis. The same goes for companies whose revenue swings wildly from year to year.
Steady, established companies are much better candidates for evaluation using DCF. Their cash flows are more likely to be consistent, so you can estimate future cash flows more accurately.
How to apply DCF
DCF is a pretty detailed valuation model. To use it, you need a specific set of inputs, the formula itself, and insight into how to interpret the model’s outputs.
What inputs you need before you can run DCF
Once you know which company you want to evaluate, you’ll need to gather the following details:
Free cash flow (FCF). This is the cash the business generates after paying for everything it needs to operate and grow. You start with the company’s operating cash flow (OCF, the cash it makes from regular business activities), subtract capital expenditures, and subtract increases (or add decreases) in working capital. You’ll calculate FCF using these numbers from the inputs below.
Forecasts for revenue, profit margin, and taxes. To estimate future cash flows, you’ll need to make educated guesses about how the company’s revenue will grow, what its profit margins will be, and what taxes it will pay. These aren’t just shots in the dark; these should be informed estimates based on company data, historical trends, and industry research.
Capital expenditures (CapEx). These are the investments a company makes to support its growth. It includes things like buildings, equipment, and tech. It’s cash out the door, so it’s important to account for these expenses when you’re calculating FCF.
Working capital. This is money used for running the business day to day. Think inventory, receivables, payables, etc. When a company grows, it often needs more of this. Like CapEx, changes in working capital affect FCF. Increases in working capital are subtracted from FCF, while decreases are added. Both CapEx and working capital numbers can be pulled from a company’s financial statements.
DCF analysis is only as reliable as its inputs. That’s why research is so important. Experienced investors dedicate serious time to making sure their forecasts and assumptions are as fact-based and reasonable as possible.
The length of your forecast window is critical, too. You’ll want to strive for a five- to 10-year window. That’s long enough to be able to capture meaningful growth, but not so long that your assumptions become total guesswork.
How to build a DCF model
Once you have all your inputs, you’re ready to start putting the pieces together. The next step is to take your free cash flow projections and discount them back to today’s dollars to see what the company is really worth.
Step 1: Project future free cash flows
Use your forecasts for revenue, profit margins, and taxes to estimate the company’s cash flows for each year in your five- to 10-year forecast. Then, subtract CapEx and changes in working capital to calculate FCF for each year.
Step 2: Estimate terminal value
The company will continue operating and generating cash flows after your forecast period. Enter terminal value.
Terminal value represents all the cash flows a company is expected to generate after your forecast period ends. Essentially, the company’s long-term, ongoing value. Because most businesses continue operating for many years, the terminal value often makes up between 60% and 80% of a DCF’s total value. That’s why even small changes to your assumptions can have a big impact on your final valuation.
There are two ways to estimate terminal value:
Perpetuity growth method. This assumes the company grows slowly and steadily forever.
Exit multiple method. This assumes the company could be valued at a multiple of a financial metric (usually EBITDA, which is earnings before interest, taxes, depreciation, and amortization), based on how similar businesses are priced.
Step 3: Discount everything back to today
Remember: DCF is based on the principle that future cash flows are worth less than cash in your hand today. To account for that, DCF analysis uses a discount rate to convert future dollars into present value.
The discount rate is essentially the rate of return you would expect from an investment with similar risk in the same industry — which is what many beginner investors use to get started with DCF.
For more advanced investors, the discount rate is often calculated using methods like weighted average cost of capital (WACC) or capital asset pricing model (CAPM).
WACC is the company’s “average cost” of raising money. It combines what the company pays on its debt (like loans or bonds, adjusted for taxes) with what investors expect to earn for owning its stock, and weights each one based on how much the company relies on debt versus equity. Think of it as the overall rate of return the company needs to generate to keep both lenders and investors happy.
CAPM looks only at the stock side. It estimates the return shareholders expect based on how risky the company’s stock is compared with the broader market. In other words, it tells you what return investors want for taking on the risk of owning this particular stock.
Once you have a discount rate, you can convert each future cash flow into its present value. This tells you how much those future dollars are worth in today’s terms. Here’s a very simple example:
Let’s say your DCF model estimates that your target company will generate $110 million in FCF next year, and you’re using a 10% discount rate. That $110 million in the future is worth about $100 million today.
Step 4: Add it all up
Once you’ve discounted all your future cash flows and your terminal value, it’s time to combine them. That will give you the company’s estimated intrinsic value. Basically, what the company is worth today based on your projections. Here’s an example:
In step 3, we calculated a company’s FCF for next year to be worth about $100 million in present value. Let’s say your DCF also projected the next five years of cash flows. After discounting each of those years to today’s dollars, the total present value of those cash flows comes to $400 million. Add that to your discounted terminal value — we’ll call it $800 million — and the intrinsic value of the company would be $1.2 billion.
That number is also your estimate of the company’s value today, which you can use to compare with its current market price to evaluate whether the company seems undervalued or overvalued.
Understanding DCF outputs
DCF analysis ends in a single number: the estimated intrinsic value of the company today. Estimated is the key word. That number is not a precise measurement; it reflects your assumptions and forecasting.
That’s why investors who are experienced with DCF analysis create a valuation range, rather than relying on that one figure.
There are a few ways to create a range:
Change the revenue growth slightly. Even a small adjustment in your forecasted revenue growth can have a big impact on projected cash flows. Test a few different growth rates to see how much the final valuation changes.
Try different margin assumptions. The same goes for your assumptions about profit margins. Running your DCF model using slightly higher or lower margins can help you capture best- and worst-case scenarios, which can be useful for a range.
Test a higher or lower discount rate. The discount rate reflects both TVM and risk. Plug in a range of reasonable (i.e., not too far in either direction) discount rates to see how changes to either factor could affect the company’s present value.
Run a bull case, base case, and bear case. You can use combinations of your different forecasts and discount rates to create models of optimistic, realistic, and pessimistic market scenarios, which can help give you a clear picture of how high or low the company’s value could go, as well as what’s most likely.
Playing around with your assumptions to see what your model spits out can also reveal a red flag. If small tweaks change your valuation dramatically, it could be a sign that the company is difficult to properly evaluate and might require more caution.
Pros and cons of DCF
No investment analysis method is perfect, and that includes DCF. While it offers a detailed, logic-based estimate of a company’s intrinsic value, it also relies heavily on assumptions, meaning it’s only as good as the inputs you provide (which adds a lot of pressure to make sure your assumptions are solid).
Advantages of DCF
It’s forward-looking. Unlike other valuation methods that focus on historical performance, DCF considers likely future performance, which helps you make decisions based on what the business is likely to generate down the line.
It focuses on actual business fundamentals. DCF emphasizes a company’s financial metrics (like revenue, margins, and FCF), instead of just market sentiment or stock price trends. This keeps it grounded and helps you avoid being swayed by market hype or panic.
You can model different scenarios. The ability to plug in different inputs to create a range is hugely helpful for getting a more nuanced sense of a company’s value.
Drawbacks of DCF
It’s not the best for young or unpredictable companies. Startups or companies with inconsistent or volatile cash flows make accurate forecasting nearly impossible, which can make DCF estimates unreliable.
Terminal value often dominates the result. Because terminal value can account for between 60% and 80% of the total valuation, any small change in the inputs used to calculate terminal value can dramatically affect the final estimate.
The model is detailed, but the output can still vary widely depending on your inputs. Even though DCF requires careful, step-by-step calculations, the final number is only an estimate, largely based on what you have personally forecasted. It’s a tool to inform decisions, but not a guarantee of true value.
Best practices for using DCF
Keep assumptions consistent. Make sure your revenue growth, profit margin, and discount rate assumptions align with each other and with the company’s track record and financial statements.
Avoid aggressive growth predictions. Stick to realistic projections that are grounded in the company’s historical performance and industry norms. Overly optimistic forecasting can inflate your valuation, which can lead you to not-so-solid investment decisions.
Update your inputs when new information is available. As companies release new financial statements or market conditions change, refresh your assumptions to keep your DCF model as accurate as possible.
Treat results as a range. Create a range instead of relying on a single number to account for uncertainty and possibly off-base assumptions.
DCF analysis isn’t going to give you a flawless prediction of a company’s value. It’s a framework to help you think clearly about what is driving a business’ worth now and in the future, and whether that worth is something you can feel confident investing in. DCF is most useful when it’s combined with other financial modeling and valuation tools, like fundamental analysis, sector analysis, and a variety of key ratios.
