DCF (discounted cash flow)

A DCF model has three moving parts: a projection of future free cash flow over some forecast window, usually five to ten years; a discount rate, typically a weighted average cost of capital, that converts future dollars into present-day value; and a terminal value estimate that captures everything beyond the forecast window, since a company doesn't stop generating cash the day the explicit forecast ends. Summing the discounted forecast-period cash flows and the discounted terminal value gives an enterprise value, which then gets adjusted for debt and cash to arrive at a per-share fair value.

The single most important thing to know about any DCF output is which assumptions drove it, since the model is only as good as its inputs. A small change in the assumed growth rate or discount rate can swing the fair value estimate by a meaningful percentage, more so than most other valuation approaches. Read a DCF fair value alongside the assumptions behind it, not as a standalone number, and treat it as one estimate among several rather than a precise target price.

A DCF is only as reliable as its forecast, and forecasting a company's cash flows five or ten years out is genuinely difficult, especially for younger companies or ones in cyclical or fast-changing industries. Small, reasonable-looking changes in the discount rate or terminal growth assumption can move the fair value estimate by 20% or more, which is why two analysts using the same underlying numbers can land on very different DCF valuations. It also says nothing about market sentiment or timing. A stock can trade below its DCF fair value for years if the market simply isn't pricing it that way yet, and the model gives no signal for when, or whether, that gap closes.

A mature industrial company generates $500 million in free cash flow this year. A DCF model projects that growing 4% annually for ten years, discounts those cash flows at a 9% weighted average cost of capital, and adds a terminal value assuming 2.5% perpetual growth after that. The resulting enterprise value, once adjusted for the company's net debt, works out to a fair value of $68 per share against a current market price of $61, suggesting the stock trades at roughly an 11% discount to the model's estimate. Bump the discount rate up just one point to 10%, holding everything else constant, and that same model's fair value estimate drops to around $59, below the current price, showing how sensitive the whole exercise is to a single input.