Investing is all about making smart decisions. But how do you know if a stock is actually worth the price you’re paying? Some stocks are undervalued gems, while others are overhyped and overpriced. That’s where Discounted Free Cash Flow (DCF) analysis comes in—it helps you determine what a company is really worth based on its future potential.
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What is Intrinsic Value?
Intrinsic value is the real worth of a company based on its ability to generate cash in the future.
Imagine you’re buying a small bakery. You wouldn’t just look at how much it made yesterday—you’d think about how much money it will bring in over the next several years. A stock works the same way.
The market price of a stock can go up and down based on news, hype, or investor emotions. But intrinsic value focuses on the business itself—not the daily stock price movements.
How Does Discounted Free Cash Flow Work?
1: Looking at Free Cash Flow (FCF)
A company’s Free Cash Flow (FCF) is the money it has left after paying all expenses. Think of it as your personal budget—after covering rent, bills, and groceries, the money left over is what you can save or reinvest.
A business with strong and growing free cash flow has more money to expand, develop new products, or reward investors. That’s a great sign!
2: Adjusting for the Time Value of Money
A dollar today is worth more than a dollar ten years from now. Why? Because you could invest that dollar today and make more money over time.
That’s why future cash flow needs to be discounted—or adjusted—so we can see what it’s really worth today.
3: Estimating Future Growth
A company’s cash flow doesn’t stay the same. Some businesses grow quickly, like a tech startup, while others grow steadily, like a well-established utility company.
By estimating how much a company’s cash flow will grow in the future, we can get a better picture of its long-term potential.
4: Factoring in Terminal Value
Companies don’t stop making money after 10 years. That’s where terminal value comes in—it estimates how much the company will continue to grow beyond the next decade.
Think of it like a rental property. Even after paying off the mortgage, the house still generates rental income. A business, if well-managed, can keep growing long after we stop our calculations.
5: Comparing to the Stock Price
Now that we have the company’s intrinsic value, we compare it to its current stock price.
- If the stock price is lower than the intrinsic value → the stock might be undervalued (a great buying opportunity).
- If the stock price is higher than the intrinsic value → the stock might be overvalued (potentially overpriced).
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