Every stock price is an opinion about the future. A discounted cash flow (DCF) model turns that opinion into arithmetic: estimate the cash a business will generate, then figure out what that future cash is worth in today's dollars. This guide walks through each step — no finance degree required.
1. Start with free cash flow, not earnings
Earnings are an accounting construct. Free cash flow (FCF) — operating cash flow minus capital expenditures — is the money a business actually produces after maintaining itself. It is the pool every investor return (dividends, buybacks, debt paydown) ultimately comes from, which is why serious valuation starts there rather than with net income or EPS.
One caution that matters enormously: for banks, insurers, and lenders, "free cash flow" as reported includes loan principal and deposits flowing in and out. Their FCF can run many times net income and means something completely different than a manufacturer's. Any DCF on a financial company deserves a skeptical eye — our screener flags exactly this pattern.
2. Project growth, then fade it
No company grows fast forever. A typical model projects elevated growth for a number of years — often anchored in the company's own recent history — then fades toward a low perpetual "terminal" rate close to long-run economic growth (2–3%). The choice of growth rate is where most of a DCF's uncertainty lives: nudge it a point and the fair value can swing 20–30%.
A practical guardrail: base growth on multi-year averages rather than a single hot year. If a company's best year was a rebound from a loss, annualizing that bounce produces fantasy growth rates — and fantasy valuations.
3. Discount the future back to today
A dollar next year is worth less than a dollar today, because today's dollar can earn a return meanwhile. The discount rate — usually the weighted average cost of capital (WACC), around 8–12% for most public companies — encodes that time value plus risk. Each projected year's cash flow is divided by the discount factor, so distant years count for less. This is the "discounted" in discounted cash flow.
4. Add a terminal value
Companies (hopefully) outlive any projection window, so the model adds a terminal value: all cash flows beyond the forecast, collapsed into one number using the perpetual growth formula. It routinely makes up half or more of the total valuation — which is why the terminal growth assumption deserves as much scrutiny as near-term growth.
5. Compare fair value to price
Divide the resulting equity value by shares outstanding and you get a fair value per share. Above the market price suggests undervaluation; below suggests overvaluation. Sensible investors demand a margin of safety — only acting when the discount is large enough to absorb all the assumptions that could be wrong.
What a DCF can't do
A DCF is a disciplined way to organize your beliefs, not a truth machine. It can't predict fraud, regulation, technological disruption, or a CEO's capital-allocation whims. Concentrated voting control, VIE structures, and accounting quirks all sit outside the math — worth checking separately before trusting any model's output.
Try it on real filings
Theory is nice; running the numbers on 10-K data is better. Our stock screener computes DCF fair values from a decade of SEC filings for thousands of US companies — free, with every input traceable to the filing it came from.