What is it? DCF is a mathematical equation (aka Fair Value) of a stock, using future earnings to determine the stock’s current price. This process is taught in major universities around the world and used by renowned investor Benjamin Graham and his protégée Warren Buffett.

Why is it Important? Investors buy stocks with the expectation that these companies are going to grow profits which in turn should translate into stock prices moving higher. Discounting the future growth of a company with a reasonable overall market return, against its current and projected earnings, leaves us with a share price of what we should be paying for a company. Just like in Real Estate, you do not want to buy something that is currently overvalued.

How do you use it? In its simplest terms, we should look to invest in a company that is currently trading at or under its Fair Value price. In doing so we are buying into a company at a discount. A stock that is trading under its Fair Value price could be a potential takeover target or at the very least when the markets fall your stock will already be discounted and should still be trading at a good price point to the rest of the market. No need for the large institutions to sell off your company if your stock is still undervalued. One last thought, the best approach should be to find a company you like and then use the DCF valuation process to make sure you are not paying more than you want/need to.

 



A great example of how the DCF formula can keep you out of trouble is with Riverbad Technology, RVBD. The stock is trading at $42.07 and of the 21 different analysts that follow the stock, they report that their average 12 month price target is $39.91.

Using the Fair Value model, the Fair Value is only $7.16, quite a bit lower than what the analysts are telling you is a good price. Do a little more research on the company and you would find the stock only made $0.27 in profit durring the past 12 months and is expected to grow their 5 year earnings at a rate of 27%. RVBD also has an extremely high P/E ratio of 157.70 meaning it will take you 157.70 years for you to get your initial investment back out of RVBD and then AFTER those 157.70 years, you can start looking for a positive return.

It's always good to have a second opinion. The analysts can give their short term target price but a non biased mathmetical formula should help the average investor trade a bit more like Warren Buffett.

 

The DCF formula: P = E₁Q + E₂Q² + ... + E_NQ^N + E_NQ^N x Q/(1 - Q)

Where E₁ is the earnings in year 1 and E₂ is the earnings in year 2… and Q is the "discount factor" 1/(1 + R).  In most examples the future earnings should be estimated out for at least 5 years before discounting them.

You can find more about stock evaluation models in the book Investment Valuation by Aswath Damodaran.