DCF Valuation Explained: Complete Guide
Learn how to calculate a stock's intrinsic value using discounted cash flow (DCF) analysis - the valuation method used by Warren Buffett and professional investors.
What is DCF Valuation?
Discounted Cash Flow (DCF) valuation is a method to estimate the intrinsic value of an investment based on its projected future cash flows. The core principle is simple: a company is worth the present value of all the cash it will generate in the future.
DCF analysis answers the fundamental question: "How much is this business worth based on the cash it will generate?" Unlike relative valuation methods (P/E ratios, comparables), DCF focuses on absolute value derived from fundamental economics.
"Price is what you pay. Value is what you get." - Warren Buffett
DCF helps you determine value, so you don't overpay for a stock.
How to Calculate DCF Valuation: Step-by-Step
Project Future Free Cash Flows
Estimate the company's free cash flow for the next 5-10 years. Start with current FCF and apply realistic growth rates based on historical performance, industry trends, and competitive position. Be conservative - overly optimistic projections destroy DCF accuracy.
Calculate the Discount Rate (WACC)
Determine the Weighted Average Cost of Capital (WACC) which reflects the risk and opportunity cost of investing in this stock. WACC considers the cost of equity (using CAPM) and cost of debt, weighted by capital structure. Higher risk = higher WACC = lower value.
Calculate Terminal Value
Estimate the company's value beyond the projection period using the perpetuity growth method (FCF × (1+g) / (WACC-g)) or exit multiple method. Terminal value often represents 60-80% of total value, so be conservative with the growth rate.
Discount Cash Flows to Present Value
Discount each future cash flow and the terminal value back to present value using the formula: PV = FV / (1 + WACC)^n. This accounts for the time value of money - a dollar today is worth more than a dollar tomorrow.
Calculate Intrinsic Value Per Share
Sum all discounted cash flows and terminal value to get enterprise value. Subtract net debt and divide by shares outstanding to get intrinsic value per share. Compare this to the current stock price to determine if it's undervalued.
DCF Formula Breakdown
Enterprise Value Formula
WACC Formula
E = Equity value, D = Debt value, V = E + D, Re = Cost of equity (CAPM), Rd = Cost of debt, Tc = Tax rate
Terminal Value Formula
FCFn+1 = Free cash flow in year after projection period, g = Perpetual growth rate (typically 2-3%)
DCF Valuation Example
Example: Valuing a Tech Company
Assumptions:
- • Current FCF: $100M
- • Growth: 20% (Y1), 18% (Y2), 15% (Y3), 12% (Y4), 10% (Y5)
- • WACC: 10%
- • Terminal growth rate: 3%
- • Shares outstanding: 50M
- • Net debt: $200M
Projected Cash Flows:
| Year | FCF ($M) | Discount Factor | PV ($M) |
|---|---|---|---|
| 1 | $120 | 0.909 | $109 |
| 2 | $142 | 0.826 | $117 |
| 3 | $163 | 0.751 | $122 |
| 4 | $183 | 0.683 | $125 |
| 5 | $201 | 0.621 | $125 |
| Sum of PV (Years 1-5) | $598M | ||
Terminal Value Calculation:
Year 6 FCF = $201M × 1.03 = $207M
Terminal Value = $207M / (0.10 - 0.03) = $2,957M
PV of Terminal Value = $2,957M × 0.621 = $1,836M
Final Valuation:
Enterprise Value = $598M + $1,836M = $2,434M
Less: Net Debt = -$200M
Equity Value = $2,234M
Intrinsic Value per Share = $2,234M / 50M = $44.68
Investment Decision: If the stock trades at $35, it's undervalued by 28%, offering a margin of safety. If it trades at $50, it's overvalued by 12% and should be avoided.
Key DCF Considerations
Growth Rate Assumptions
Be conservative. High growth rates rarely sustain beyond 5-7 years. Use historical growth, industry benchmarks, and competitive analysis. Err on the side of caution - it's better to be pleasantly surprised than disappointed.
WACC Selection
WACC significantly impacts valuation. Small changes (8% vs 10%) can swing value by 20-30%. Use risk-free rate + equity risk premium × beta for cost of equity. Higher risk companies require higher WACC, reducing value.
Terminal Value Sensitivity
Terminal value often represents 60-80% of total value. Use conservative perpetual growth rates (2-3%). Run sensitivity analysis - if small changes drastically alter value, your assumptions need refinement.
Margin of Safety
Never pay full intrinsic value. Require a 20-40% discount (margin of safety) to account for assumption errors, unexpected events, and market volatility. The greater the uncertainty, the larger the margin required.
Practice DCF with These Stocks
Apply DCF valuation to these companies with predictable cash flows:
Common DCF Mistakes to Avoid
Overly Optimistic Growth Projections
Using 20%+ growth for 10 years implies the company will be massive. Most companies' growth slows significantly after 5-7 years. Be realistic and conservative.
Using Too Low a Discount Rate
Low WACC inflates valuations artificially. Risk must be properly reflected in the discount rate. Small-cap, cyclical, or leveraged companies need higher WACC than large-cap stable businesses.
Ignoring Capital Requirements
Growth requires capital. Don't forget to account for working capital increases and capital expenditures when projecting free cash flow. High-growth companies often burn cash initially.
False Precision
DCF is not precise to the penny. If your model says intrinsic value is $47.83, understand there's significant uncertainty. Focus on whether it's roughly $40, $50, or $60, not exact decimals.
Frequently Asked Questions
What is DCF valuation and why is it important?
DCF (Discounted Cash Flow) valuation is a method to estimate a stock's intrinsic value based on projected future cash flows discounted to present value. It's considered the gold standard of valuation because it focuses on the fundamental economic value a business generates, rather than market sentiment or comparable multiples. Warren Buffett and other value investors rely heavily on DCF analysis.
How do you calculate DCF valuation?
Calculate DCF in five steps: (1) Project free cash flows for 5-10 years, (2) Calculate the discount rate (WACC) reflecting the investment's risk, (3) Calculate terminal value representing cash flows beyond the projection period, (4) Discount all cash flows to present value using WACC, (5) Sum the present values and divide by shares outstanding to get intrinsic value per share.
What is WACC and how do you calculate it?
WACC (Weighted Average Cost of Capital) is the blended cost of a company's debt and equity financing. Calculate it as: WACC = (E/V × Cost of Equity) + (D/V × Cost of Debt × (1-Tax Rate)), where E is equity value, D is debt value, and V is total value (E+D). Cost of equity is typically calculated using CAPM. WACC represents the minimum return the company must generate to satisfy investors.
What is terminal value in DCF?
Terminal value estimates a company's value beyond the explicit forecast period (typically after year 5-10). It's calculated using either: (1) Perpetuity Growth Method: Terminal Value = Final Year FCF × (1+g) / (WACC - g), where g is the perpetual growth rate (typically 2-3%), or (2) Exit Multiple Method: Terminal Value = Final Year EBITDA × Exit Multiple. Terminal value often represents 60-80% of total DCF value.
What is a good DCF value for a stock?
A stock is potentially undervalued if its DCF intrinsic value significantly exceeds the current market price. Value investors typically look for a "margin of safety" of 20-30% or more - meaning they want to buy at $70 or less if intrinsic value is $100. This buffer protects against errors in assumptions and provides upside potential. If intrinsic value is below market price, the stock may be overvalued.
What are the limitations of DCF valuation?
DCF limitations include: (1) Garbage in, garbage out - accuracy depends entirely on assumptions about growth, margins, and WACC, (2) Long projection periods compound errors, (3) Terminal value assumptions can dramatically change results, (4) Doesn't work well for unprofitable companies or those with negative FCF, (5) Doesn't capture qualitative factors like brand value or management quality. Always use DCF alongside other valuation methods.
How do you project free cash flow for DCF?
Start with historical FCF and apply realistic growth rates: (1) Analyze 5-10 years of historical revenue growth and margins, (2) Consider industry trends, competitive position, and market size, (3) Project revenue growth (typically declining over time toward GDP growth), (4) Estimate operating margins based on historical performance, (5) Calculate taxes, working capital changes, and capex, (6) Derive FCF = Operating Cash Flow - Capital Expenditures. Be conservative - optimism destroys DCF accuracy.
What is a reasonable growth rate for terminal value?
The terminal growth rate should be conservative, typically 2-3% (around long-term GDP growth). Using rates above 4-5% implies the company will eventually exceed the size of the entire economy, which is unrealistic. Even the best companies eventually mature and grow at GDP rates. Higher terminal growth rates can dramatically inflate valuation, so be conservative and run sensitivity analyses.
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