Discounted Cash Flow
Discounted cash flow (DCF) analysis values a stock (or any investment) as the present value of all expected future cash flows. It is more general than the dividend discount model (DDM) because it can use free cash flow, not just dividends, making it applicable to any company, including those that do not pay dividends.
Think of it this way: A dollar you receive next year is worth less than a dollar today, because you could invest today's dollar and earn a return. DCF takes every dollar a company is expected to generate in the future, adjusts each one for this time-value-of-money effect, and adds them up. The total is the stock's intrinsic value.
Core Formula
- r = discount rate (required rate of return)
- n = number of periods in the future
DCF vs. DDM
| Feature | Dividend Discount Model | Discounted Cash Flow |
|---|---|---|
| Cash flow used | Dividends only | Free cash flow (or any projected cash flow) |
| Best for | Stable dividend payers | Any company, including non-dividend payers |
| Scope | Equity holders only | Entire business (enterprise value) |
| Growth assumption | Constant dividend growth (Gordon) | Can model variable growth rates |
DDM is actually a specific type of DCF that uses dividends as the cash flow. DCF is the broader, more flexible model.
Exam Tip: Gotchas
- DCF is the broader concept; DDM is a specific type of DCF. If a question says "present value of all future cash flows," the answer is DCF. If it specifically says "present value of all future dividends," the answer is DDM.
Key Relationships
- Higher discount rate (required return) = lower present value = lower intrinsic value
- Higher expected cash flows = higher present value = higher intrinsic value
- Longer time horizon = greater impact of discounting on distant cash flows
- If intrinsic value > market price, the stock is considered undervalued (buy signal)
- If intrinsic value < market price, the stock is considered overvalued (sell signal)
Exam Tip: Gotchas
- A higher discount rate lowers intrinsic value. When a question raises the required rate of return (or risk premium) without changing cash flows, the DCF valuation must FALL. This is the most commonly tested sensitivity in DCF problems.
Enterprise Value to Equity Value
- DCF typically produces an enterprise value (value of the entire business)
- Subtract net debt (total debt minus cash) to get equity value
- Divide equity value by shares outstanding to get intrinsic value per share
Comparison of All Four Valuation Methods
| Method | Data Used | Best For | Core Assumption |
|---|---|---|---|
| Technical analysis | Price and volume history | Short-term trading | Patterns repeat; price reflects all info |
| Fundamental analysis | Financial statements, economics | Active stock picking | Markets misprice; intrinsic value exists |
| Dividend discount | Expected dividends | Dividend-paying stocks | Value = present value of dividends |
| Discounted cash flow | Expected free cash flows | Any company | Value = present value of cash flows |