DCF — Discounted Cash Flows

Discounted cash flows (DCF) is a valuation method that aims to determine a company's current value by projecting its future cash flows and discounting them back to today's value. This method is particularly valuable for institutional investors seeking a thorough and theoretically solid basis for their investment decisions, especially for companies with complex revenue streams or in industries expected to grow significantly.

By focusing on the company's ability to generate cash flows over time, DCF gives a more fundamental assessment than valuations based on historical valuation multiples.

The core of DCF analysis is that a stock's value equals the present value of all future cash flows that a shareholder can expect to receive. This requires careful assumptions about future growth, profitability, capital needs and a discount rate that reflects the risk associated with realizing these cash flows.

Despite its complexity and dependence on subjective assumptions, the DCF method is an indispensable tool for distinguishing a fundamentally under- or overvalued stock from the market's current price.

The practical application of the DCF method begins by projecting the company's free cash flows (FCF) over an explicit period, usually five to ten years. These forecasts must be based on a deep understanding of the company's historical performance, industry dynamics and competition. To arrive at a valuation, the analyst must then calculate a terminal value, which represents the value of all cash flows generated after the explicit forecast period.

This is usually done by assuming a constant, perpetual growth rate and applying a Gordon Growth model. Finally, both the projected cash flows and the terminal value are discounted back to the present value using the company's weighted average cost of capital (WACC).

The result of this calculation is the total enterprise value. To obtain the theoretical stock value, the company's liabilities and any liquid funds are deducted from this value. The final value is then compared with the current market value to determine whether the stock is over- or undervalued.

A sensitivity analysis is an indispensable part of the process, in which one tests how changed assumptions about growth, profitability and WACC affect the final stock value, giving a more nuanced picture of the valuation's uncertainty.