DCF Valuation Explained in Plain Words

A discounted cash flow, or DCF, is a way to estimate what a company's shares could be worth. It starts from one idea: a company is worth the cash it will pay its owners in the future, and cash that comes later is worth less than cash today.

The steps

1. Start with free cash flow per share. This is the cash left after running costs and the money the business needs to invest. It is in the cash flow statement in the company's annual report.
2. Guess how it grows. For example, 8% a year for 5 years, then 5% a year for 5 more.
3. Pick the return you want. This is the discount rate. Each year's cash is divided by (1 + that rate) for every year you wait.
4. Add a value for the years after year 10. This is the terminal value. It assumes the cash grows at a slow, steady rate forever, such as 2.5%.
5. Add it all up. The total is the estimated value per share.

A worked example

Free cash flow of $5 a share, growing 8% for 5 years then 5% for 5 years, then 2.5% forever. You want a 9% yearly return.

Try it in the DCF calculator. If the shares cost $100, the estimate is about 8% above that price. Reducing the estimate by a 20% cushion gives about $87, a more careful figure to compare with the price.

The big catch

More than half of that $108 comes from the years after year 10. That is normal for a DCF, and it is why the answer swings so much when you change the long-term growth or the discount rate. Look at the what-if table, not just one number.

The traps

• Hopeful growth. Few companies grow 20% a year for long. Start from what the company has really done.
• A low discount rate. It makes the value look high. Some investors use 8% to 10% for stocks.
• Growth forever above the economy. Long-term growth of more than about 3% means the company eventually outgrows the whole economy.
• Negative cash flow. A DCF does not work for a company that is not yet making cash.
• False precision. A result like $108.15 looks exact. It is not.

A margin of safety

Because your guesses can be wrong, an investor who uses a margin of safety compares the price with an estimate that has been reduced by a cushion, such as 20%. The calculator shows that lower figure next to your estimate.

What it is not

A DCF is a way to check your own thinking. It is not a forecast, and it does not tell you what to buy or sell. It also leaves out a company's debt, changes in the number of shares and pay in shares, and it does not suit banks or insurers. To compare a result with other options, try the IRR calculator.

Sources

• Background reading, Investor.gov: Annual return
• Background reading, Investor.gov: Compound interest
• Background reading, Investor.gov: Compound interest calculator

This article is for education and is not financial, tax or legal advice. Figures are checked against the sources above and may change. Read the full disclaimer.