Tutorial: use a DCF without fooling yourself
Do not ask the DCF what the company is worth. Ask it what today's price is assuming, then decide if you believe it.
Use a valuation model as an argument you can inspect, rather than an answer you can hide behind.
How use a DCF without fooling yourself works, in one picture
The same argument as the text, as a chain. Each step is what makes the next one possible.
The order matters more than the maths
Cheapness is the last question. Ask it first and you produce a list of companies the market has given up on, and it is usually right.
- 1
Understand what you are actually doing
A DCF says a business is worth all the cash it will ever produce, converted into today's money. That is not a trick, it is the definition of value. The trouble is entirely in the forecasting.
- 2
Look at where the value is hiding
Valuation LabTypically 60 to 80% of the answer sits in the terminal value: the part representing everything after your forecast ends, which is the part you have just admitted you cannot forecast. Anyone quoting a DCF output to two decimal places has not looked at this.
The terminal formula divides by (discount rate minus growth). Nudge growth up towards the discount rate and the valuation runs to infinity. The maths will happily oblige you.
- 3
Break it on purpose
Move the discount rate by one point and watch fair value swing by a third. This is not a flaw you should hide. It is the model telling you how much of your answer is assumption rather than analysis.
- 4
Now run it backwards
Instead of producing a value, feed in today's price and solve for the growth rate that justifies it. Now you have a single, checkable claim: 'the market thinks this grows 14% a year for a decade'. You can have an opinion about that. You cannot really have an opinion about a fair value of 62.40.
You can state the growth rate today's price implies, and say whether you believe it.
Read next
Do not ask the DCF what the company is worth. Ask it what today's price is assuming, then decide if you believe it.
Our DCF against the market price, with the exact method printed, and the circumstances in which it is wrong printed next to it.