What Is DCF (Discounted Cash Flow) and How It Determines Fair Value
A simple explanation of the most common method for pricing stocks: what free cash flow is, why it's discounted, and why the discount rate has such a big impact on the result.
The basic idea
DCF (Discounted Cash Flow) is based on a simple principle: the value of an asset is the sum of all the money it will generate in the future, adjusted for the fact that a dollar today is worth more than a dollar in five years. A company worth investing in is one whose future free cash flow, discounted to today's value, is higher than the stock's current market price.
Free cash flow — not accounting profit
The calculation doesn't start from "net income" on the income statement, but from free cash flow — the money that actually remains in the company's coffers after all operating expenses and the capital investments required to keep the business running. The difference matters: a company can show high accounting profit but weak cash flow (for example, due to heavy capital investments), or the reverse.
The discount rate — the variable that moves everything
To discount future cash flow to a present value, you need a discount rate — usually derived from the company's weighted average cost of capital (WACC), which also factors in risk. This is the most sensitive part of the model: a change of a single percentage point in the discount rate can shift the calculated value by tens of percent. That's why DCF estimates from different models (or different calculators) can look very different from one another — all 'correct' mathematically, but based on different assumptions.
Why it matters and why it isn't precise
DCF is one of the most useful tools for assessing whether a stock is cheap or expensive relative to what the company actually generates, instead of only comparing it to similar stocks (as a P/E multiple does). But it's highly sensitive to assumptions about future growth and the discount rate — both of which are forecasts, not facts. StockIQ weighs DCF together with additional pricing methods (NAV and multiple comparisons) precisely to avoid relying on a single model with that kind of sensitivity.
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The information in this guide is intended for general educational purposes only and does not constitute investment advice. Full details on the disclaimer page.