By Ben McClure
While the concept behind discounted cash flow analysis is simple, its practical application can be a different matter. The premise of the discounted cash flow method is that the current value of a company is simply the present value of its future cash flows that are attributable to shareholders. Its calculation is as follows:
For simplicity's sake, if we know that a company will generate $1 per share in cash flow for shareholders every year into the future; we can calculate what this type of cash flow is worth today. This value is then compared to the current value of the company to determine whether the company is a good investment, based on it being undervalued or overvalued.
There are several different techniques within the discounted cash flow realm of valuation, essentially differing on what type of cash flow is used in the analysis. The dividend discount model focuses on the dividends the company pays to shareholders, while the cash flow model looks at the cash that can be paid to shareholders after all expenses, reinvestments and debt repayments have been made. But conceptually they are the same, as it is the present value of these streams that are taken into consideration.
As we mentioned before, the difficulty lies in the implementation of the model as there are a considerable amount of estimates and assumptions that go into the model. As you can imagine, forecasting the revenue and expenses for a firm five or 10 years into the future can be considerably difficult. Nevertheless, DCF is a valuable tool used by both analysts and everyday investors to estimate a company's value.
For more information and indepth instructions, see the Discounted Cash Flow Analysis tutorial.
Ratio Valuation
Financial ratios are mathematical calculations using figures mainly from the financial statements, and they are used to gain an idea of a company's valuation and financial performance. Some of the most wellknown valuation ratios are pricetoearnings and pricetobook. Each valuation ratio uses different measures in its calculations. For example, pricetobook compares the price per share to the company's book value.
The calculations produced by the valuation ratios are used to gain some understanding of the company's value. The ratios are compared on an absolute basis, in which there are threshold values. For example, in pricetobook, companies trading below '1' are considered undervalued. Valuation ratios are also compared to the historical values of the ratio for the company, along with comparisons to competitors and the overall market itself.
Fundamental Analysis: Conclusion
Related Articles

Investing
How To Choose The Best Stock Valuation Method
There is no single valuation tactic that works in every situation. But a company’s characteristics provide clues to investors about the best method to use. 
Investing
Value Investing: Why Investors Care About Free Cash Flow Over EBITDA
Examine value investing philosophy and methodology to see why free cash flow is more important than EBITDA in pure intrinsic value calculation. 
Investing
Analyzing The PriceToCashFlow Ratio
Find out how this ratio can help you evaluate companies and make investment decisions. 
Investing
Analyze Cash Flow The Easy Way
Find out how to analyze the way a company spends its money to determine whether there will be any money left for investors. 
Trading
Free Cash Flow Yield: A Fundamental Indicator
Free cash flow can measure a business’s performance as if you’re looking at its net income line. 
Investing
Cash Flow From Investing
Cash flow analysis is a critical process for both companies and investors. Find out what you need to know about it. 
Markets
How Do I Value Shares I Own In A Private Company?
The most common method, and easiest to use, is to compare valuation ratios for a private company against those for a comparable public company. 
Investing
Should You Use DCF for Valuation?
We explain the two primary valuation techniques—DCF and Comparables—used to predict future stock prices. 
Investing
Fundamental Case Study: Is Amazon's Cash Flow Actually Solid? (AMZN)
Review Amazon's cash flow situation, including its free cash flow yield, operating cash flow from organic growth and cash flow from debt financing. 
Investing
Evaluate Stock Price With ReverseEngineering DCF
This is a more accurate method to use when trying to find a target price for a stock.