How to Value a Stock with a DCF (Discounted Cash Flow)
Learn how a discounted cash flow model estimates a stock's intrinsic value, why the terminal value and discount rate matter so much, and how to use it.
Published
Free tool: DCF CalculatorA discounted cash flow (DCF) model values a business by estimating the cash it will generate in the future and converting that cash into today's dollars. If the result per share is well above the stock price, the stock may be undervalued. This guide walks through a two-stage DCF with a worked example, using the free DCF Calculator.
How a DCF works
- Project free cash flow: the cash a business generates after operating costs and investment. The calculator grows it at one rate for years 1 to 5 and another for years 6 to 10.
- Estimate a terminal value for everything after year 10, assuming steady growth forever.
- Discount it all to today at your required return.
- Adjust for the balance sheet: add cash and subtract debt to get the equity value, then divide by the number of shares.
Example
A company with $1,000 million of free cash flow, growing 10% a year for 5 years and 6% for the next 5, then 2.5% forever, with a 9% discount rate, 500 million shares and $2,000 million of net cash:
- Free cash flow grows from $1,100 million in year 1 to about $2,155 million in year 10.
- Present value of those 10 years: about $9,956 million
- Present value of the terminal value: about $14,356 million
- Enterprise value: about $24,312 million; equity value: $26,312 million
- Intrinsic value: $52.62 per share
At a $40 share price, that's 31.6% above the price. With a 20% margin of safety, you'd buy below $42.10.
The terminal value dominates
In the example, 59% of the value comes from after year 10. That's typical, and it means small changes to the long-term assumptions move the answer a lot:
| Discount rate | Terminal growth 2% | 2.5% | 3% |
|---|---|---|---|
| 8% | $58.88 | $62.15 | $66.07 |
| 9% | $50.44 | $52.62 | $55.17 |
| 10% | $44.15 | $45.67 | $47.41 |
Cutting the discount rate by one point raises the value by about 18%; raising it by one point lowers it by about 13%.
Choosing the inputs
- Free cash flow: start from the last 12 months, and normalize unusual years.
- Growth rates: compare with the company's history and its industry; high growth rarely lasts 10 years.
- Terminal growth: usually no higher than long-run economic growth, often 2% to 3%.
- Discount rate: your required return, often 8% to 10% for a typical large company, higher for riskier ones.
A DCF is only as good as its assumptions. Use it to understand what the price implies, test optimistic and pessimistic cases, and keep a margin of safety.
How to use the DCF Calculator
- Open the DCF Calculator.
- Enter the last 12 months of free cash flow and the growth for years 1 to 5 and 6 to 10.
- Enter the terminal growth rate and your discount rate.
- Enter the shares outstanding and net cash (negative for net debt), in millions, plus the current share price and the margin of safety you want.
- Read the results: the intrinsic value per share, the buy-below price, the enterprise and equity values and the share of value from after year 10, with charts of projected cash flow and where the value comes from, and a sensitivity table.
To see how the same discounting works for any investment, see How to Calculate NPV.
Frequently asked questions
What is intrinsic value in a DCF?
The present value of a company's expected future free cash flows, plus net cash, divided by the number of shares. In the example, $52.62 per share.
What discount rate should I use for a DCF?
Your required return for the risk, often 8% to 10% for a large, stable company and higher for smaller or riskier ones. The result is very sensitive to it.
Why is the terminal value so large?
Because it covers every year after year 10. It often makes up half or more of a DCF value, which is why the terminal growth rate needs to be conservative.