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🧠 How does DCF work?
The Discounted Cash Flow method starts with a simple idea: a company's value today = the sum of all the cash it will generate in the future, brought back to today's value.
Why "bring back"? Because $1 received in 5 years is worth less than $1 today (inflation, risk, opportunity cost). We discount each future cash flow using the WACC.
Simplified formula:
Value = Σ (FCF_year_n / (1 + WACC)^n) + (Terminal Value / (1 + WACC)^5)
Terminal Value = (FCF_year_5 × (1 + g_terminal)) / (WACC - g_terminal)
↑ Gordon-Shapiro formula
We typically project FCF over 5 to 10 years (explicit period), then compute a "terminal value" representing everything the company will produce beyond that, assuming stable infinite growth (often 2-3% — close to long-term GDP).
Enterprise value is then adjusted: add net cash (or subtract debt) to get equity value, divided by shares outstanding to get intrinsic value per share.
⚠️ DCF limitations (worth knowing)
DCF is not magic. Its known weaknesses:
- Garbage in, garbage out — the result is only as good as your assumptions. A 5%-too-high growth estimate can double the valuation.
- WACC sensitivity — moving from 8% to 10% can drop value by 30-40%. Small changes, big impact.
- Terminal value = 60-80% of total — most of the valuation comes from the distant, most uncertain future.
- Unsuitable for young companies — if FCF is not yet positive (startups, biotech), DCF is unusable as-is.
- Misses network effects, brand, patents — intangible assets are poorly captured.
- Assumes macro stability — rate regime change, recession, tech disruption: the model doesn't see it coming.
Best practice: compute multiple scenarios (bear / base / bull), apply a 25-50% margin of safety, and always cross-check DCF with other methods.
⚖️ DCF vs other methods (P/E, EV/EBITDA)
DCF is just one method among several. Pros always use multiple angles:
| Method | Strengths | Weaknesses |
|---|---|---|
| DCF | Fundamental method, accounts for future cash flows | Highly sensitive to assumptions |
| P/E (Price/Earnings) | Ultra simple, usable everywhere | Manipulable (accounting earnings), ignores debt |
| EV/EBITDA | Compares differently-leveraged firms, neutralizes tax | Ignores CapEx (useless for capital-intensive companies) |
| Comparables | Reflects market sentiment | If the sector is in a bubble, you validate the bubble |
| Dividend Discount | Good for utilities and mature dividend payers | Useless for growth names with no dividends |
Our take: use DCF as the primary method for mature companies with stable FCF, then cross-check with P/E and EV/EBITDA. For growth/tech, complement with sector multiples.
❓ FAQ
What is a DCF (Discounted Cash Flow)?
DCF is a valuation method that estimates a company's value as the discounted sum of its future cash flows. It is the preferred method of Warren Buffett and most professional financial analysts.
How do I find a stock's Free Cash Flow?
FCF is in the company's annual (10-K) or quarterly report, in the cash flow statement. Formula: Cash Flow from Operations - Capital Expenditures. Also available on StockAnalysis, Yahoo Finance, or directly inside Alpha Terminal.
What WACC should I use for my DCF?
Quick approximation: 8-10% for stable large caps (Apple, Microsoft), 10-13% for mid/small caps, 13%+ for risky companies or startups. Full formula: WACC = (E/V × Re) + (D/V × Rd × (1-T)).
Is the DCF reliable?
DCF is highly sensitive to assumptions (garbage in, garbage out). Small variation in WACC or terminal growth = large variation in value. Use it as one of several methods (P/E, EV/EBITDA, comparables), never alone.
What margin of safety should I apply?
Benjamin Graham and Warren Buffett recommend a 25-50% margin of safety on the calculated intrinsic value. If your DCF gives $100 and the stock trades at $70 or below, it's a potential buy signal.
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