Discounted Cash Flow (DCF) is a valuation method used to estimate the present value of an investment based on its expected future cash flows. It is one of the most fundamental tools in financial analysis, used by Wall Street analysts and individual investors alike.
1. Project Cash Flows
Estimate how much free cash flow the company will generate each year for the next 10 years based on a growth rate assumption.
2. Discount to Present
Future dollars are worth less than today's dollars. The discount rate (WACC) converts future cash flows into today's terms.
3. Add Terminal Value
The terminal value captures all cash flows beyond year 10 using the Gordon Growth Model, then discount it back to present value.
The resulting intrinsic value per share tells you what the stock is theoretically "worth" based on fundamentals. Comparing this to the current market price gives you the Margin of Safety- a concept popularized by Benjamin Graham and used by Warren Buffett.