Discounted Cash Flow for Stocks: A Working Guide

Discounted cash flow (DCF) values a stock by the cash the company will actually produce: project free cash flow into the future, discount it back at a risk-adjusted rate, add the terminal value beyond the forecast window, and divide by shares outstanding. The result is an intrinsic value per share — the price tag the model says the business deserves, independent of whatever the market is doing this week. It is the most rigorous way to value a stock, and the most honest about its own assumptions.

Free cash flow: the starting point

Free cash flow is the cash left after operating expenses and capital spending — the money the business can actually return to shareholders or reinvest. Earnings include accounting choices (depreciation schedules, one-off items); free cash flow is closer to the truth of what the company generated. It is also the anchor of valuation: a company growing earnings but burning cash is not growing value.

Growth, discount rate and the forecast period

• Growth rate: anchor to what the company has actually done and what its industry supports — 8-10% is a strong long-run assumption for a good business, 15%+ is exceptional and usually temporary
• Discount rate: the cost of capital, typically 8-12% for most companies — higher for volatile businesses, lower for stable cash cows; this is the risk statement in the model
• Forecast period: 5-10 years is the working standard; beyond that, honest projections become fiction

Terminal value: the big assumption

After the forecast window, the company is assumed to keep growing at a modest perpetual rate — 2-3% nominal, roughly long-run GDP-plus-inflation — and its value becomes a growing perpetuity: terminal value equals next year's cash flow divided by (discount rate minus growth). The uncomfortable fact: this single number usually makes up 60-80% of the valuation. The model's verdict is only as strong as the terminal assumption, which is why the honest response to any DCF is to stress-test growth and discount by two points each way and see if the verdict survives.

A worked DCF

                Yearly FCF: 108.0, 116.6, 126.0, 136.1, 146.9 ($M)
Discounted PVs: 98.2, 96.4, 94.6, 92.9, 91.2 → $473.4M
Terminal value: 146.9 x 1.03 / (0.10 - 0.03) = $2,162M
PV of terminal value: 2,162 / 1.6105 = $1,342.4M
Enterprise value: 473.4 + 1,342.4 = $1,815.8M
Per share: 1,815.8 / 50 = ~$36.30 intrinsic value
Terminal value is 74% of the total — the model lives or dies there
              

Margin of safety

Every input is an estimate, and small errors compound into big ones — raising growth from 8% to 10% or dropping the discount from 10% to 8% moves the intrinsic value by 30-50%. The margin of safety is the investor's answer: only buy when the market price sits meaningfully below intrinsic value — 20-30% under is the classic working standard — so that being wrong about the assumptions still leaves you whole. Warren Buffett's framing is the standard: it is the gap between the price you pay and the value you get, and it is the only protection against your own estimates.

DCFs also make the market's behavior legible. When a stock trades far above its DCF value, the market is either pricing faster growth than your assumption, using a lower discount rate, or paying sentiment's price. Run the model backwards: what growth rate would justify today's price? If the answer is 20% for a grocery chain, you have learned something about the price without buying anything. Pair the model with the P/E ratio calculator for the market-multiple cross-check and the dividend discount model calculator for stable dividend payers, where dividends substitute for cash flow.

DCF is a discipline, not a prophecy