Investing Assets & Markets Stocks How to Use the Discounted Cash Flow Model To Value Stock When You're Looking at a Company's Value, Cash Flow Is King By Tim Lemke Tim Lemke Twitter Tim Lemke has more than 20 years of experience as a writer. He specializes in writing about investing, cryptocurrency, stocks, banking, business, and more. He has also been published in The Washington Times, Washington Business Journal, Wise Bread, and Patch. In 2019, he joined investment management company T. Rowe Price as a senior writer. learn about our editorial policies Updated on October 31, 2021 Reviewed by Charles Potters Reviewed by Charles Potters Charles is a nationally recognized capital markets specialist and educator with over 30 years of experience developing in-depth training programs for burgeoning financial professionals. Charles has taught at a number of institutions including Goldman Sachs, Morgan Stanley, Societe Generale, and many more. learn about our financial review board Share Tweet Pin Email In This Article View All In This Article What Is the Discounted Cash Flow Model? The DCF Model Formula Advantages and Limitations of the DCF Model Frequently Asked Questions (FAQs) Photo: Evgeniia Siiankovskaia / Getty Images Before investing in a company, you need to look at a few crucial factors. Many models exist to evaluate a company's financial health and calculate estimated returns to reach an objective share price. One great way to do it is by measuring the company's cash flow. This means looking at how much money a company has at the end of the year, compared to the beginning of the year. What Is the Discounted Cash Flow Model? The discounted cash flow model (DCF) is one common way to value an entire company. When you use the DCF to value a company, you are able to decide how much its shares of stock should cost. DCF is considered an “absolute value” model. It uses objective financial data to evaluate a company, instead of comparisons to other firms. The dividend discount model (DDM) is another absolute value model that is widely accepted, though it may not be appropriate for certain companies. The DCF Model Formula The DCF formula is more complex than other models, including the dividend discount model. The formula is: Present value = [CF1 / (1+k)] + [CF2 / (1+k)2] + ... [TCF / (k-g)] / (1+k)n-1] That looks fairly tricky, but let’s define the terms: CF1: The expected cash flow in year oneCF2: The expected cash flow in year twoTCF: The “terminal cash flow,” or expected cash flow overall. This is usually an estimate, as calculating anything beyond five years or so is guessworkk: The discount rate, also known as the required rate of returng: The expected growth raten: The number of years included in the model There is a simpler way of looking at this, however. Let’s look at a small fictional company, Dinosaurs Unlimited. Suppose we’re calculating for five years out, the discount rate is 10%, and the growth rate is 5%. Note: There are two different ways of calculating terminal cash flow. For simplicity, let’s assume the terminal value is three times the value of the fifth year. If we assume that Dinosaurs Unlimited has a cash flow of $1 million now, its discounted cash flow after a year would be $909,000. We arrive at that number by assuming a discount rate of 10%. In the years that follow, cash flow is increasing by 5%. Thus, new discounted cash flow figures over a five-year period are: Year 2: $867,700Year 3: $828,300Year 4: $792,800Year 5: $754,900 We noted above that the terminal value will be three times that of the value in the fifth year, so that comes to $2.265 million. Add all these figures, and you come to $6.41 million. Based on this analysis, that's the value of Dinosaurs Unlimited. But what if Dinosaurs Unlimited were a publicly traded company? We could determine whether its share price was fair, too expensive, or a potential bargain. Let’s assume that Dinosaurs Unlimited is trading at $10 per share, and there are 500,000 shares outstanding. That represents a market capitalization of $5 million. Thus, a $10 share price is on the low side. If you are an investor, you might be willing to pay nearly $13 per share, based on the value stemming from the DCF. Pros and Cons of the DCF Model Accounting scandals in recent years have placed a new importance on cash flow as a metric for determining proper valuations. Cash flow, however, can be misleading in some instances. If a company sells a lot of its assets, for example, it may have positive cash flow but may actually be worthless without them. It’s also crucial to note whether a company is sitting on piles of cash or reinvesting back into itself. Note Cash flow is generally harder to manipulate in earnings reports than are profits and revenue. Like other models, the discounted cash flow model is only as good as the information entered, and that can be a problem if you don't have access to accurate cash flow figures. It’s also harder to calculate than other metrics, such as those that simply divide the share price by earnings. If you are willing to do the work, this can be a good way to decide whether it's a sound idea to invest in a company. Frequently Asked Questions (FAQs) Why would DCF and ROPI give you a different stock value for the same company? The discounted cash flow (DCF) and residual operating income (ROPI) are similar valuation methods, but ROPI uses balance sheet and income state information, including accrual accounting information. DCF does not factor in the effects of accrual accounting. How do you treat stock-based compensation when calculating DCF? Stock-based compensation (SBC) can inflate the value of a company when using DCF calculations. DCF does not account for accrual-based income, and there isn't a commonly accepted way to account for SBC while measuring cash flow. SBC is often added back into the company's value as a non-cash expense, like depreciation, even though it eventually becomes a real cost to investors. Was this page helpful? Thanks for your feedback! Tell us why! Other Submit Sources The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy. CFI. "Guide to the Discounted Cash Flow DCF Formula." Babson College. "Analyzing and Valuing Equity Securities," Page 12. Columbia Law School. "Stock-Based Compensation, Financial Analysts, and Equity Overvaluation."