Discounted Cash Flow

A popular stock valuation approach to discover the fair value of a stock uses a method known as discounted cash flow, or DCF for short.

You see, buying a stock is just like buying a business. You buy a business for the cash it is able to generate and in the case of a stock, earnings per share is what really matters.

Thus, the true value of a stock should reflect the total amount of earnings that company is able to generate over its lifetime.  This value then has to be discounted to account for the additional risk of ownership as well as the effects of the time value of money.

While in theory, we should be looking at the free cash flow rather than earnings, but in practice, obtaining the free cash flow can get rather cumbersome and furthermore, both figures approximates to the same value in the long run.

The result obtained will be the fair value of the company which you can then use to assess whether the stock is currently overvalued or undervalued by the market.

For this exercise, we will be looking at a stock XYZ which has a current EPS of $1 and assumed to grow at 15% for the next 5 years and growth to slow to 5% the following 5 years before leveling off thereafter.

Next: Forecasting Future Earnings

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