The following post is in continuation with the previous one, so I recommend that you read it first.

DCF is a stock valuation model which uses the present value of future cash flows of a company to assess the present fair/intrinsic value of a company’s share.

Translating the above paragraph from finance nerd to nerd: it means that if we discount(opposite of compound) the future cash flows of a company, and thus calculate their present value. We can use that data to basically calculate the intrinsic value of a share.

The major assumption of this model is the time value of money, which says that money today is worth more than the same amount tomorrow.

The model has alot of pros, and the results are a pretty good indicator of a company’s value. But the major con is, that the more we go into the future with our predictions, more inaccurate the model gets.

The method:

1) Predict future free cash flows: typically future free cash flows are predicted 5-10 years in the future and this is done by analysing past free cash flows of the company. This is where your creativity as an investor comes into play. Try to keep your predictions conservative.

2) Calculate the discount rate: the discount rate in a dcf model is the WACC. I’ll talk more about wacc in the next post.

3) Calculate the terminal value: terminal value(tv) is the value of the business beyond the predicted cash flow period. It assumes that the business will grow at a set growth rate forever. It’s formula is: [CF*(1+g)]/(r-g) here, CF is the last predicted cash flow, r is the discount rate/wacc and g is the terminal growth rate.

4) Discount the cash flows and the tv to present value: now the cash flows and tv are discounted back to present value. This is done using the formula:

C here is the predicted cash flow, r is the WACC and n is the number of periods. For eg: for the 5th year, n=5.

For the TV, value n is the same as preceding year’s value of n. For eg, if I’ve predicted cash flows of 10 years, then to discount tv, the formula would be: TV/[(1+R)^10]

5) Calculate the equity value: calculate enterprise value by summing all the discounted cash flows and the discounted tv. Add to it company’s cash balances and subtract the long term debts of the company. The number obtained now is the equity value. We have subtracted the debts because the purpose was to arrive at a figure which belongs to the shareholders only.

6) Divide equity value by shares outstanding: dividing the equity value by the amount of shares outstanding will finally give us the intrinsic share price of the company. Phew, that was hard af!