How to Estimate a Stock's Fair Value With a Simple DCF

Value = the sum of every future cash flow, each divided by (1 + r) raised to the number of years away it arrives. That’s the whole model. Money later is worth less than money now. The discount rate r sets how much less, and everything else in a discounted cash flow model, from the growth rate to the terminal value, is a structured way of guessing what those future cash flows will turn out to be.

Start from free cash flow

Take operating cash flow and subtract capital expenditures. Both sit on the cash flow statement in the 10-K or 10-Q. What remains is the cash left once the business has paid to keep itself running. Use the trailing twelve months, and look at several years of history before trusting any single one, since a big working capital swing or a pause in spending can inflate one year badly. Free cash flow covers the variations in how tools calculate it.

For the example, a hypothetical company with trailing free cash flow of $100 million.

Project five years

Pick a growth rate for the next five years. It is the most visible guess in the model, so write down why you chose it: recent revenue growth, the margin trend, what management has guided to, what peers are doing. For the example, 8% a year.

Year 1 is $100M × 1.08 = $108M. Each later year multiplies the one before by 1.08 again.

Add a terminal value

A company doesn’t stop at year five. The terminal value stands in for everything after, using the Gordon growth formula: the final year’s free cash flow, grown one more year at a long-run rate g, divided by the gap between the discount rate and that long-run rate.

Terminal value = FCF in year 5 × (1 + g) ÷ (r − g)

The long-run rate should be modest. No company outgrows the economy forever, so g is usually set low, at or below the pace you expect for the economy as a whole. Keep it well under r. As g approaches r, the denominator shrinks toward zero and the terminal value shoots toward infinity, which is the formula telling you the inputs make no sense together.

Discount and add it up

Each cash flow gets divided by (1 + r)^t, where t is the year. The terminal value is discounted as a year-five amount. Here r is 10%, the return you require for owning this stock; many analysts use a weighted cost of capital, and either way it is an input you choose.

Look at where that value came from. The terminal value is about $1,342M of the $1,816M total, roughly three quarters. Most of the answer rests on what happens after year five. That is the stretch you know least about.

Get from enterprise value to a share price

The discounted cash flows value the whole business. Lenders have a claim on it too. Subtract net debt, meaning total debt minus cash, to find what is left for shareholders, or add the difference if the company holds more cash than debt, and then divide by the diluted share count from the latest filing so that options and convertible securities are counted alongside the ordinary shares.

Test the inputs

A single number hides how fragile it is. Rerun the model across a small grid. Change the discount rate and the terminal growth rate, and hold everything else fixed.

Discount rate	g = 2%	g = 3%	g = 4%
9%	$31.56	$36.52	$43.45
10%	$26.73	$30.32	$35.10
11%	$22.98	$25.67	$29.13

The same company, the same cash flows for five years, and the value runs from about $23 to about $43 a share on changes of one point in each of two inputs. That range is the honest output of a DCF. If the stock trades at $28, the model says it could be cheap or expensive depending on assumptions nobody can pin down, and fair value is a set of assumptions makes the case for reading it that way.

If the stock trades at $15, well below every cell in the grid, that is more interesting, and a reason to dig into why the market disagrees. See how to look for undervalued stocks for screening.

Run it yourself

The DCF calculator takes the same inputs. It does the discounting for you. Change one assumption at a time and watch the value move. Build the grid there before settling on any single number.

What goes wrong

Starting from a free cash flow figure that isn’t normal is the first trap. One unusually strong year, projected forward and capitalized into a terminal value, inflates every figure after it. Growth assumptions that sit well above the company’s own history are the second. The third is a discount rate chosen to hit a number you already wanted, which you can catch by writing the rate down before you see the result.