Show pageOld revisionsBacklinksBack to top This page is read only. You can view the source, but not change it. Ask your administrator if you think this is wrong. ======Discounted Cash Flow (DCF)====== Discounted Cash Flow (DCF) analysis is a powerful valuation method used to estimate a company's true worth, or what [[Warren Buffett]] calls its [[intrinsic value]]. Imagine you're offered the chance to buy a magical apple tree. You wouldn't pay just any price for it; you'd want to estimate how many apples it will produce over its lifetime and what those future apples are worth to you //today//. That's precisely what DCF does for a business. It projects a company’s future [[cash flow]]—the actual cash it generates—and then "discounts" it back to the present day. Why discount it? Because a dollar in your pocket today is worth more than a promise of a dollar a year from now, due to inflation and the [[opportunity cost]] of not having that money to invest elsewhere. By summing up all those discounted future cash flows, you arrive at a single number representing the company's estimated value. This helps an investor decide if a stock is currently trading at a bargain price, a fair price, or if it's wildly overpriced. ===== The Magic Formula: How DCF Works ===== At its core, a DCF valuation is the sum of a company's projected future cash flows, all converted into today's money. It sounds complex, but it breaks down into three key ingredients. ==== Step 1: Forecasting Free Cash Flow ==== This is the most critical, and most challenging, part of the analysis. You need to estimate the company's [[free cash flow]] (FCF) for a certain period, typically 5 to 10 years. FCF is the cash a company has left over after paying for its day-to-day operations and investing in long-term assets like buildings and equipment. It's the "apples from the tree"—the real cash that could be returned to shareholders. A good forecast requires a deep understanding of the business, its industry, its competitive advantages (or [[moat]]), and its growth prospects. ==== Step 2: Choosing a Discount Rate ==== Once you've projected the future cash flows, you need to bring them back to their present value. For this, you use a [[discount rate]]. The discount rate is an interest rate that reflects the riskiness of the investment. A stable, predictable business like Coca-Cola would use a lower discount rate than a volatile tech startup. A higher discount rate means future cash is worth less today, resulting in a lower valuation. Many professionals use the [[WACC]] (Weighted Average Cost of Capital), but a simpler approach for individual investors is to use the rate of return they could expect from their next best investment idea (their opportunity cost). ==== Step 3: Calculating Terminal Value ==== A business doesn't just stop operating after 10 years. To account for its value beyond your forecast period, you must calculate a [[terminal value]]. This single number represents the value of all cash flows from the end of your forecast period into perpetuity, discounted back to the present. Be warned: the terminal value can often account for over 50% of the total DCF valuation, making it a very powerful and sensitive assumption. ===== A Peek Under the Hood: A Simple Example ===== Let's put this into practice. Imagine you're analyzing "Awesome Widgets Inc." * **Forecast:** You project it will generate $100 in free cash flow next year (Year 1) and $110 in Year 2. * **Discount Rate:** You believe a 10% discount rate is appropriate for the risk involved. * **Calculation:** - The present value of Year 1's cash flow is: $100 / (1.10) = **$90.91** - The present value of Year 2's cash flow is: $110 / (1.10 x 1.10) = **$90.91** You would continue this for your entire forecast period and then add the present value of your terminal value calculation. The sum of all these numbers is your estimate of Awesome Widgets' [[net present value]] (NPV), or its intrinsic value. ===== A Value Investor's Best Friend (and Worst Enemy) ===== For [[value investing]] purists, the DCF is the gold standard of valuation. It forces you to think like a business owner, not a stock market speculator. ==== The Buffett Perspective ==== Warren Buffett's partner, [[Charlie Munger]], famously said, "I've never seen Warren do a DCF." This is a bit of a joke. What he means is that Buffett doesn't need to build a complex spreadsheet for every investment. For a truly great business that he understands deeply, the calculation becomes almost intuitive. The //thinking process// behind DCF—projecting future cash generation and weighing it against the current price—is embedded in his every decision. The DCF model is simply a formal framework for that exact thought process. ==== The "Garbage In, Garbage Out" Problem ==== A DCF's greatest strength is also its greatest weakness. The final valuation is extremely sensitive to the assumptions you input. If you use overly optimistic growth rates and a low discount rate, you can justify paying almost any price for a stock. This is why financial analysts often joke that DCF stands for "Damn Cash Flow," "Delusional Cash Flow," or "Do-able Cash Flow". This is where the concept of a [[margin of safety]] becomes your most important tool. Because your DCF is //only an estimate//, you must insist on buying a stock for a price that is significantly below your conservative calculation of its intrinsic value. This discount provides a cushion in case your forecasts are wrong. ===== Key Takeaways ===== * DCF calculates what a business is worth today based on the cash it's expected to generate in the future. * It is a core tool for value investors because it focuses on a business's long-term earning power, not short-term market sentiment. * The three key ingredients are: future cash flow projections, a discount rate, and a terminal value. * **Beware!** A DCF is an estimate, not a fact. Its output is highly sensitive to the assumptions you feed it. Always use conservative estimates and demand a significant margin of safety before investing.