Discounted Cash Flow Analysis

Financial ratios and multiples – including metrics like debt-to-equity ratio, price-earnings ratio and return on equity – provide a quick way for investors to determine the general value of a stock compared to other investments in the market. If you want to estimate the absolute value of a company, however, discounted cash flow (DCF) analysis can come in handy. It takes into account the time value of money – the idea that the money that’s available today is worth more than the same amount in the future because of its potential earning capacity.

Finance professionals often use the discounted cash flow (DCF) valuation method to determine the attractiveness of an investment opportunity. DCF analysis uses future free cash flow (FCF) projections  and discounts them to estimate the present value, which is then used to evaluate the investment potential. In general, if DCF analysis indicates a value that is higher than the current cost of the investment, it signals a good opportunity. For example, if you estimate a stock is worth $50 based on your DCF analysis – and it’s currently trading at $30 – you know the stock is undervalued.

In simple terms, DCF analysis attempts to value a project, company or asset today, based on how much money it’s projected to make in the future, with the idea that the value is inherently contingent on its ability generate cash flows for investors.

There are several variations when it comes to DCF analysis, and each is based on multiple assumptions, such as the amount of future cash flows, timing of cash flow, cost of capital, growth rate. Even a small change in a single assumption can result in very different valuation results – which helps explain why market analysts often come up with varying price target estimates when placing a fair value on companies.

Here, we’ll focus on the free cash flow to equity approach to DCF analysis – the one that’s commonly used by Wall Street analysts to determine the fair value of companies. In this tutorial, we’ll guide you through DCF analysis with a step-by-step example using ACME Corp. – a hypothetical U.S.-based manufacturing company. We’ll start by looking at how to determine the forecast period for your analysis and how to forecast revenue growth.