what is Discounted Cash Flow (DCF) in valuation analysis of a stock

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Discounted Cash Flow, or DCF, is a fundamental valuation method used to determine the intrinsic value of a stock. The concept is simple: a company's value equals the present value of all its future cash flows. We project the cash flows the company will generate over time, then discount them back to today's value using an appropriate discount rate. The DCF process involves five key steps. First, we project the company's future free cash flows, typically for 5 to 10 years. Second, we estimate the terminal value representing cash flows beyond our forecast period. Third, we determine the discount rate, usually the Weighted Average Cost of Capital or WACC, which reflects the company's cost of financing. Fourth, we discount all future cash flows to present value. Finally, we sum these present values to arrive at the company's intrinsic value. Let's work through a practical DCF example. Consider a company with projected free cash flows of 100 million in year one, 110 million in year two, and 121 million in year three. We estimate a terminal value of 1.5 billion and use a WACC of 10 percent. Using the discount factor of one divided by one plus WACC raised to the power of the year, we calculate present values. The total present value sums to approximately 1.4 billion dollars, representing the company's intrinsic value. DCF analysis is highly sensitive to key assumptions. Small changes in the discount rate, growth rates, or terminal value estimates can dramatically impact the final valuation. This sensitivity chart shows how company valuation decreases as the WACC increases. A one percent change in WACC can alter valuation by hundreds of millions. This is why analysts often perform sensitivity analysis and scenario modeling to understand the range of possible outcomes and test the robustness of their DCF models. DCF analysis offers several key advantages. It's based on fundamental company value, considers the time value of money, and provides a forward-looking perspective. However, it also has significant limitations. DCF is highly sensitive to assumptions, making accurate cash flow predictions challenging. Terminal value estimates can vary widely, and the method doesn't account for market sentiment or timing. While DCF provides valuable insights into intrinsic value, analysts should validate assumptions carefully and consider it alongside other valuation methods for a comprehensive investment analysis.