Discounted Cash Flow Analysis
  1. DCF Analysis: Introduction
  2. DCF Analysis: The Forecast Period & Forecasting Revenue Growth
  3. DCF Analysis: Forecasting Free Cash Flows
  4. DCF Analysis: Calculating The Discount Rate
  5. DCF Analysis: Coming Up With A Fair Value
  6. DCF Analysis: Pros & Cons Of DCF
  7. DCF Analysis: Conclusion

DCF Analysis: Introduction

By Ben McClure
Contact Ben

It can be hard to understand how stock analysts come up with "fair value" for companies, or why their target price estimates vary so wildly. The answer often lies in how they use the valuation method known as discounted cash flow
(DCF). However, you don't have to rely on the word of analysts. With some preparation and the right tools, you can value a company's stock yourself using this method. This tutorial will show you how, taking you step-by-step through a discounted cash flow analysis of a fictional company.

In simple terms, discounted cash flow tries to work out the value of a company today, based on projections of how much money it's going to make in the future. DCF analysis says that a company is worth all of the cash that it could make available to investors in the future. It is described as"discounted" cash flow because cash in the future is worth less than cash today. (To learn more, see The Essentials Of Cash Flow and Taking Stock Of Discounted Cash Flow.)

For example, let's say someone asked you to choose between receiving $100 today and receiving $100 in a year. Chances are you would take the money today, knowing that you could invest that $100 now and have more than $100 in a year's time. If you turn that thinking on its head, you are saying that the amount that you'd have in one year is worth $100 dollars today - or the discounted value is $100. Make the same calculation for all the cash you expect a company to produce in the future and you have a good measure of the company's value.

There are several tried and true approaches to discounted cash flow analysis, including the dividend discount model (DDM) approach and the cash flow to firm approach. In this tutorial, we will use the free cash flow to equity approach commonly used by Wall Street analysts to determine the "fair value" of companies.

As an investor, you have a lot to gain from mastering DCF analysis. For starters, it can serve as a reality check to the fair value prices found in brokers' reports. DCF analysis requires you to think through the factors that affect a company, such as future sales growth and profit margins. It also makes you consider the discount rate, which depends on a risk-free interest rate, the company's costs of capital and the risk its stock faces. All of this will give you an appreciation for what drives share value, and that means you can put a more realistic price tag on the company's stock.

To demonstrate how this valuation method works, this tutorial will take you step-by-step through a DCF analysis of a fictional company called The Widget Company. Let's begin by looking at how to determine the forecast period for your analysis and how to forecast revenue growth.

DCF Analysis: The Forecast Period & Forecasting Revenue Growth

  1. DCF Analysis: Introduction
  2. DCF Analysis: The Forecast Period & Forecasting Revenue Growth
  3. DCF Analysis: Forecasting Free Cash Flows
  4. DCF Analysis: Calculating The Discount Rate
  5. DCF Analysis: Coming Up With A Fair Value
  6. DCF Analysis: Pros & Cons Of DCF
  7. DCF Analysis: Conclusion
  1. Adjusted Gross Income - AGI

    A measure of income calculated from your gross income and used ...
  2. Audit

    An unbiased examination and evaluation of the financial statements ...
  3. EBITA

    Earnings before interest, taxes and amortization. To calculate ...
  4. Qualitative Analysis

    Securities analysis that uses subjective judgment based on nonquantifiable ...
  5. Profit and Loss Statement (P&L)

    A financial statement that summarizes the revenues, costs and ...
  6. Discounted Cash Flow (DCF)

    Discounted cash flow (DCF) is a valuation method used to estimate ...
  1. How is perpetuity used in determining the intrinsic value of a stock?

    Investors are often interested in determining intrinsic values of the stocks, bonds or other securities as they consider ... Read Full Answer >>
  2. Do you discount working capital in net present value (NPV)?

    Net present value (NPV) calculations should include the discounted value of changes in working capital. This treatment of ... Read Full Answer >>
  3. How is working capital different from fixed capital?

    There are several key differences between working capital and fixed capital. Most importantly, these two forms of capital ... Read Full Answer >>
  4. How can working capital affect a company's finances?

    Working capital, or total current assets minus total current liabilities, can affect a company's longer-term investment effectiveness ... Read Full Answer >>
  5. What are working capital costs?

    Working capital costs (WCC) refer to the costs of maintaining daily operations at an organization. These costs take into ... Read Full Answer >>
  6. What does low working capital say about a company's financial prospects?

    When a company has low working capital, it can mean one of two things. In most cases, low working capital means the business ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  2. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  3. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  4. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
  5. Black Monday

    October 19, 1987, when the Dow Jones Industrial Average (DJIA) lost almost 22% in a single day. That event marked the beginning ...
  6. Monetary Policy

    Monetary policy is the actions of a central bank, currency board or other regulatory committee that determine the size and ...
Trading Center