Intrinsic Value and DCF: How to Estimate What a Stock Is Worth

A stock's price is what you pay; its intrinsic value is an estimate of what the business is actually worth. If you can estimate intrinsic value reasonably well, you can judge whether a stock looks cheap or expensive. The most widely used method is the discounted cash flow (DCF) model.

The core idea

A business is worth the cash it will produce for its owners over its lifetime, adjusted for the fact that money in the future is worth less than money today. A DCF model estimates future free cash flows and "discounts" them back to today's value.

A DCF step by step

1. Start with free cash flow. Use the company's recent free cash flow as a base. Five years of history are on every StockEngine stock page.
2. Forecast growth. Estimate how fast free cash flow will grow, often over 5 to 10 years. Many models use a higher rate for the first few years and a lower one later.
3. Choose a discount rate. This is the return you require for the risk you're taking, often 8% to 12% for stocks. Riskier companies deserve a higher rate.
4. Add a terminal value. After the forecast period, assume cash flows grow slowly forever, usually at 2% to 3%, roughly in line with long-term economic growth. This value is discounted back to today too.
5. Adjust for the balance sheet. Add cash and subtract debt to move from the value of the business to the value of the shares.
6. Divide by shares outstanding to get intrinsic value per share, then compare it with the current price.

The DCF calculator does all of this for you and can load real free cash flow, cash, debt and share counts for any ticker.

Sensitivity: small changes, big differences

DCF results are very sensitive to the inputs. Raising the growth rate a few points or lowering the discount rate by one point can change the result dramatically. The terminal value often makes up more than half the total. That's why a DCF is best treated as a range, not a precise answer. Try several scenarios: pessimistic, base and optimistic.

Margin of safety

Because every estimate can be wrong, value investors look for a margin of safety: buying only when the price is well below their estimate of intrinsic value, for example 20% to 30% below. The cushion protects against mistakes in your assumptions. See growth vs. value investing.

Where DCF works and where it doesn't

• Works best for established companies with steady, positive free cash flow.
• Struggles with young companies that are losing money, highly cyclical businesses, and banks and insurers, which are usually valued with other methods such as price-to-book.

Cross-check with multiples

Compare your DCF result with simpler valuation measures such as the P/E ratio, EV/EBITDA and the PEG ratio. If they tell very different stories, revisit your assumptions. For a full research routine, see how to analyze a stock.

This article is educational and not investment advice.