A discounted cash flow model sounds like something only analysts build. The idea underneath is simple enough to do on a napkin: money in the future is worth less than money today, so you add up the cash a business will produce and shrink each year's amount by how far away it is.
A DCF projects free cash flow for several years, estimates a terminal value for everything after that, and discounts it all at a rate that reflects risk. Dividing the result by diluted shares gives a value per share. The model is only as good as its assumptions, which is why a range of scenarios beats a single number.
What to look at
- Projection period: usually 5–10 years of free cash flow, built from revenue growth and margin assumptions.
- Discount rate: the return you require for the risk. Higher rates shrink distant cash flows more.
- Terminal value: the value of all cash after the projection. It is often more than half the total, so be conservative.
- Equity value = Enterprise value − Net debt. Then divide by diluted shares.
- Sensitivity: change growth, margin and discount rate one at a time to see which assumption the value depends on.
The shape of it
Present value = Future cash ÷ (1 + discount rate)^years
An example
$100 received in 10 years, discounted at 9%, is worth about $42 today. That is why a company promising profits far in the future is so sensitive to interest rates and to its own execution.
Where people go wrong
A DCF can justify any price if you tweak the inputs. If a 1-point change in the terminal growth rate moves the value by 40%, the model is telling you how uncertain you are, not what the stock is worth.
Treat the output as a map of assumptions. The valuable question is not 'what is it worth?' but 'what would I have to believe for today's price to make sense, and do I believe it?'