Introduction to Discounted Cash Flow (DCF 1)
A beginner-friendly tutorial
Welcome to this step-by-step guide on performing a Discounted Cash Flow (DCF) analysis! Whether you're a finance student, an aspiring investor, or just curious about valuing companies, this tutorial will walk you through the process in a simple, beginner-friendly way. Hopefully after this DCF series, you’ll be able to value any company out there. Let’s dive in!
Introduction
A Discounted Cash Flow (DCF) analysis is a method used to estimate the value of a company based on its future cash flows. The core idea is simple: a dollar today is worth more than a dollar tomorrow. By forecasting a company’s future cash flows and "discounting" them back to their present value, we can determine what the company is truly worth. It is versatile in that it can be applied to any company, from startups to established giants.
Why use DCF?
DCF helps you estimate the "true" value of a company, independent of market hype or sentiment. It aids in our decision-making–It is important to not overpay, even if it's a great business–valuations matter. In the long run, stocks of great companies go up but having the tenacity to hold on to an investment in drawdowns for months or even years is tough even for a seasoned investor.
Valuation isn’t just about price—it’s about understanding what drives that price. The price of a stock is always a function of its current earnings and its expected future growth. With bonds, valuation is straightforward because the cash flows (coupon payments) are fixed and clearly stated. But for stocks, cash flows are uncertain, making valuation more complex. As analysts, we should approach valuing a stock the same way we value a bond—by estimating its future cash flows.
When doing a DCF, the key questions to answers are:
How much will the business generate?
When will it generate these cash flows?
And how certain are we about them?
Over the next few articles, we will go through in detail to do a full DCF. The main components are as below.
4 Steps to do DCF:
We forecast free cash flows (FCF) for the next 5–10 years.
Then, we calculate the weighted average cost of capital (WACC), which serves as our discount rate to bring future cash flows back to the present. This step is crucial because of the time value of money—the idea that a dollar today is worth more than a dollar in the future.
Since businesses don’t simply disappear after our forecasted period, we also estimate a terminal value to account for the company’s value beyond that horizon.
Finally, we discount all cash flows (including the terminal value) to the present, sum them up to get enterprise value (EV), and then derive the equity value which can give us the implied share price.
What You’ll Need
Financial statements (income statement, balance sheet, cash flow statement). We’ll tell you where to find them
A basic understanding of Excel or Google Sheets.
Patience and curiosity!
That’s all for this introduction and I’ll see you in the next chapter, where we discuss the concept of time value of money.
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