
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 stepbystep 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 riskfree 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 stepbystep 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.


Initial Cash Flow
The amount of money paid out or received at the start of a project ... 
Audit Trail
A stepbystep record by which accounting data can be traced ... 
Absolute Value
A business valuation method that uses discounted cash flow analysis ... 
Present Value  PV
The current worth of a future sum of money or stream of cash ... 
Fairness Opinion
A report evaluating the facts of a merger or acquisition. Fairness ... 
Fair Value
1. The estimated value of all assets and liabilities of an acquired ...

How should I evaluate a company with negative cash flow investing activities?
Understand how a negative cash flow from investing activities should be evaluated. Learn the sources and uses of cash in ... Read Answer >> 
Why are the fair value accounting rules controversial?
Find out about the controversial points to fair value trading, ranging from historical concerns to more modern issues in ... Read Answer >> 
How is perpetuity used in determining the intrinsic value of a stock?
Learn about the basics of a perpetuity, its valuation, how it is calculated and how it is used when evaluating the intrinsic ... Read Answer >> 
Is it better to use fundamental analysis, technical analysis or quantitative analysis ...
Understand the difference between fundamental, technical and quantitative analysis, and how each measurement helps investors ... Read Answer >> 
How can I use cash flow investing activities to determine if a company is growing?
Learn how to use the sources and uses of a company's cash flow from investing activities to determine whether that company ... Read Answer >> 
How do you use DCF for real estate valuation?
Learn how discounted cash flow analysis is used for real estate valuation and the various factors that go into calculating ... Read Answer >>