Introduction to Discounted Cash Flow

Different valuation ratios compare a stock's market price with financial measures such as the underlying company's earnings, book value, and dividends. These ratios provide a quick and dirty way to determine how a stock is valued, but usually require a lot of context to be useful.

It's easy to understand why a faster-growing company may deserve a higher price/earnings or price/sales ratio than a slower-growing one, but how do we go about estimating what the absolute value of any company should be? Enter discounted cash flow (DCF).

Valuation methods based on discounted cash-flow models determine stock prices in a different and more robust way. DCF models estimate what the entire company is worth. Comparing this estimate, or "intrinsic value," with the stock's current market price allows for much more of an apples-to-apples comparison. For example, if you estimate a stock is worth $75 based on a DCF model, and it is currently trading at $50, you know it's undervalued.

Estimating a stock's fair value, or intrinsic value, is no easy task. In fact, it is quite complex, involving all kinds of variables that are themselves tough to estimate. Despite their complexity, valuations based on DCF models are much more flexible than any individual ratio, and they allow an investor to incorporate assumptions about such factors as a company's growth prospects, whether its profit margins are likely to expand or contract, and how risky the company is in general.