The idea behind identifying the intrinsic value of a stock was popularised by Benjamin Graham and later Warren Buffett, which often relies heavily on Discounted Cash Flow (DCF) analysis. In this article, I will attempt to explain it simply and easily.
As an investor, there is no ‘secret sauce’ to picking stocks. But there are a range of toolkits that you can use to help you analyse a stocks value and more appropriately allocate funds. One of tools that is often used is the Discounted Cash Flow (DCF) model which helps you determine whether a stock could be a potential bargain or overpriced.
In simple terms, the DCF model is based on the very foundational financial principle of the Time Value of Money (TVM), i.e the value of an investment is determined by the present value of its future expected cash flows. It flows directly from the principle of the time value of money (money of the same value today will be worth more than the same amount in the future due to present earning potential).
In my other article, I looked at the Free Cash Flow and Free Cash Flow Payback Period as another means for analysing stocks. Feel free to check it out along with the calculator!.
Discounted Cash Flow (DCF) Analysis
Why Discounted Cash Flow Analysis Matters:
Let’s start by saying, the value of a company cannot only be determined by its current price today but rather the earning potential. DCF helps you to cut through market noise and calculate a stock’s true intrinsic value. The real value worth based on actual cash, and not hype!
How DCF Benefits You:
| Key Benefits | What It Means for You |
|---|---|
| Intrinsic Value Focus | Ignore market panic/FOMO. Value stocks based on actual cash, not headlines. |
| Long-Term Vision | Perfect for investors who care about 5-10 year returns, not next week’s short term volatility. |
| Flexibility | Works for stocks, rental properties, startups, essentially anything that produces cash… |
The Key Things to Know About DCF Analysis
1. Free Cash Flow (FCF)
- What it is: Cash left after the company pays bills and buys equipment.
- Where to find it: Company Cash flow statement (look for “Operating Cash Flow” minus “Capital Expenditures”)
- Pro Tip: Use 5-year averages to smooth out weird years (like COVID crashes).
2. Discount Rate
- What it is: Your “minimum acceptable return.” Think of this as the interest rate you’d want for future cash.
- Rule of Thumb:
- Safe stocks (Apple, Coca-Cola): 8-10%
- Risky startups: 15-20% (compensates for uncertainty)
- WACC: This is often the weighted average cost of capital for a business.
3. Growth Rate
- What it is: How fast you expect FCF to grow annually. You should be realistic. Companies rarely grow 20%+ a year. forever.
- Hack: Use historical FCF growth or industry averages. If Microsoft grew FCF by 12%/year for 5 years, start there.
4. Terminal Value
- What it is: The company’s value after your forecast period (usually 10 years).
- Simple Formula:
(Assume long-term growth = 2-3%, roughly matching inflation.)
Example Valuation Calculation using the Discount Cash Flow Model
I will use a hypothetical company for this scenario so we can strictly focus on the figures but using my calculator:
Inputs
| Parameter | Value |
|---|---|
| Currency | US Dollars ($) |
| Initial FCF | $100 million |
| Net Debt | $30 million (Debt – Cash) |
| Growth Rate (Years 1-5) | 10% p.a. |
| Growth Rate (Years 6-10) | 5% p.a. |
| Discount Rate (WACC) | 8% |
| Terminal Growth Rate | 2.5% |
| Shares Outstanding | 10 million |
| Current Share Price | $25 |
Step 1: Forecast Free Cash Flows (FCF)
We’ll project FCF for 10 years, then calculate the terminal value.
| Year | FCF Calculation | FCF (Millions) |
|---|---|---|
| 0 | Initial FCF | $100 |
| 1 | $100 × (1 + 10%) | $110 |
| 2 | $110 × 1.10 | $121 |
| 3 | $121 × 1.10 | $133.1 |
| 4 | $133.1 × 1.10 | $146.4 |
| 5 | $146.4 × 1.10 | $161.0 |
| 6 | $161.0 × (1 + 5%) | $169.1 |
| 7 | $169.1 × 1.05 | $177.5 |
| 8 | $177.5 × 1.05 | $186.4 |
| 9 | $186.4 × 1.05 | $195.7 |
| 10 | $195.7 × 1.05 | $205.5 |
Step 2: Discount Future FCF to Present Value
Use the discount rate (8%) to calculate present value (PV) of each year’s FCF:
| Year | FCF (Millions) | Discount Factor (8%) | PV of FCF (Millions) |
|---|---|---|---|
| 1 | $110 | 1/1.081=0.92591/1.081=0.9259 | $101.8 |
| 2 | $121 | 1/1.082=0.85731/1.082=0.8573 | $103.8 |
| 3 | $133.1 | 1/1.083=0.79381/1.083=0.7938 | $105.7 |
| 4 | $146.4 | 1/1.084=0.73501/1.084=0.7350 | $107.6 |
| 5 | $161.0 | 1/1.085=0.68061/1.085=0.6806 | $109.6 |
| 6 | $169.1 | 1/1.086=0.63021/1.086=0.6302 | $106.6 |
| 7 | $177.5 | 1/1.087=0.58351/1.087=0.5835 | $103.6 |
| 8 | $186.4 | 1/1.088=0.54031/1.088=0.5403 | $100.7 |
| 9 | $195.7 | 1/1.089=0.50021/1.089=0.5002 | $97.9 |
| 10 | $205.5 | 1/1.0810=0.46321/1.0810=0.4632 | $95.2 |
Total PV of FCF (Years 1-10): $1,032.5 million
Step 3: Calculate Terminal Value
Use the terminal growth rate (2.5%) to estimate perpetual cash flows after Year 10:
PV of Terminal Value:
Step 4: Total Enterprise Value (EV):
Add PV of FCF and Terminal Value:
Subtract Net Debt to get Equity Value:
Per-Share Value:
Step 5: Compare to Current Price
- Intrinsic Value: $277.6/share
- Current Price: $25/share
Verdict: The stock is undervalued by 1,010% based on DCF. (But in reality, such a massive gap usually means flawed assumptions. Double check growth rates or WACC!)
Key Assumptions & Caveats
- Growth rates decline after 5 years (adjust if unrealistic for the industry).
- Terminal growth (2.5%) should never exceed long-term GDP growth (~3%).
- WACC is sensitive: If you increase it to 10%, intrinsic value drops sharply.
Try it below, find the figures and input the code. I created a free sample within the calculator for you to test!
Discounted Cash Flow (DCF) Calculator
I am always happy to take feedback, let me know if you enjoyed the article and Discount Cash Flow calculator and feel free to check out the other tools!
If you liked this calculator, check out the other ones I made:
