Why a dollar today is worth more than a dollar tomorrow
The most important concept in valuation is time value of money: a dollar received today is worth more than a dollar received in the future. Why? Because you can invest today's dollar and earn a return. If you can earn 10% annually, $1 today becomes $1.10 in a year. So $1 received one year from now is only worth $0.91 today (since $0.91 × 1.10 = $1.00).
This creates the mathematical foundation for all valuation: future cash flows must be discounted back to today's value. The further in the future a cash flow is, the less it's worth today.
The discount rate — your required return
The discount rate is the annual return you demand for the risk you're taking. For a risk-free investment (government bonds), this might be 4-5%. For a stable, large-cap stock, you might use 8-10%. For a high-growth, speculative company, 12-15% may be appropriate.
Institutional investors typically use WACC (Weighted Average Cost of Capital) as the discount rate — a blend of the company's cost of equity and cost of debt, weighted by capital structure. For simplicity, many value investors use 10% as a baseline — it roughly represents the long-run expected return from equities.
What a DCF model actually does
A Discounted Cash Flow (DCF) model calculates intrinsic value by projecting a company's future free cash flows, discounting each one back to present value at the required return rate, and summing them up. The result is what the company's cash flows are worth in today's dollars — its intrinsic value.
The model has three main inputs: (1) current free cash flow as the starting point, (2) a projected growth rate for the next 5-10 years, and (3) a terminal value representing all cash flows beyond the projection period. The terminal value typically accounts for 60-80% of total intrinsic value — making it the most important and most uncertain input.
Free Cash Flow
Starting point. Current FCF represents the business's baseline cash generation. All projections build from this number.
Growth Rate
How fast will FCF grow? Conservative: 5-8% for stable companies. Aggressive: 15-25% for high-growth. Higher growth = higher intrinsic value.
Discount Rate
Your required return. Higher rate = lower intrinsic value. 10% is a common baseline for equity analysis.
If you require a 10% annual return, what is the present value of $1,000 to be received in 2 years?
DCF calculation: a step-by-step example
Let's walk through a simplified DCF for a fictional company called "MegaCorp." MegaCorp generates $1 billion in free cash flow this year, grows at 10% annually, and we'll use a 10% discount rate. The company has 500 million shares outstanding.
Note: When growth = discount rate, each year's discounted value equals the initial FCF — a mathematical coincidence in this example. In practice they differ.
DCF Intrinsic Value Build-Up — MegaCorp Example
Margin of safety — the most important concept in value investing
Even the most careful DCF model is built on assumptions that could be wrong. Growth may slow. Margins may compress. A new competitor may emerge. Benjamin Graham's solution: always demand a significant discount between calculated intrinsic value and the price you pay. This buffer is the margin of safety.
Graham recommended buying at 30-50% below intrinsic value. Warren Buffett is slightly less strict but always insists on some margin — he calls it "paying 50 cents for a dollar." The margin of safety isn't cowardice — it's rational acknowledgment that all valuation models are approximations.
Real-world example: Apple's intrinsic value in 2016
When Warren Buffett's Berkshire Hathaway began buying Apple in early 2016, the stock traded near $90-95 per share. A simplified DCF using Apple's 2015 FCF of $70 billion, a conservative 8% FCF growth rate, a 10% discount rate, and 3% terminal growth rate would have produced an intrinsic value estimate in the range of $130-150 per share.
Buffett was buying at approximately a 35-40% discount to a conservative intrinsic value estimate. The margin of safety was enormous — and it protected him from being wrong. Even if Apple's FCF growth came in at only 4% (half his conservative estimate), the stock at $90 still represented compelling value.
By 2020, Apple traded above $300 per share. The intrinsic value didn't change because of Buffett's purchase — but the market's willingness to recognize that value did. This is the essence of value investing: buy a great business at a meaningful discount, and wait.
Common DCF mistakes that destroy investment returns
Why it hurts
It's easy to project 20-25% growth for 10 years. It almost never happens. Even the best companies revert toward GDP growth over long periods. The higher the projected growth, the more the intrinsic value depends on assumptions that are statistically unlikely to be achieved.
How to avoid
Run a base case (conservative), bull case (optimistic), and bear case (pessimistic). Make sure the stock makes sense in the base case, not just the bull case.
Why it hurts
As shown in the MegaCorp example, 70-80% of intrinsic value typically comes from the terminal value. A 1% change in terminal growth rate from 3% to 4% increases terminal value by 17% in our example. Most investors calculate terminal value once and never stress-test it.
How to avoid
Run your DCF with terminal growth rates of 2%, 3%, and 4%. If intrinsic value swings dramatically, your estimate is fragile — demand a larger margin of safety.
Why it hurts
High-growth, speculative companies have far more uncertainty than stable, predictable businesses. Using 10% for both Apple and a pre-revenue biotech gives the same weight to vastly different risk profiles.
How to avoid
Use 8-9% for blue-chip compounders, 10-12% for mid-cap growth, 13-15%+ for speculative businesses. Higher uncertainty = higher required return.
Why it hurts
Your DCF gives you an estimate of value today based on current assumptions. It is not a price target. The stock may remain mispriced for months or years. Buffett bought Apple at $90 — it went to $150 over two years, not two weeks.
How to avoid
Be patient. Intrinsic value is a compass, not a GPS. It tells you the direction to walk, not exactly how far you'll travel or when you'll arrive.
Your DCF calculates intrinsic value at $75 per share. The stock trades at $50. Applying Graham's 30% margin of safety rule, should you buy?
Put it into practice
Pick a company in Liv2Trade's markets. Look up its latest FCF. Run a back-of-envelope DCF at 10% growth and 10% discount rate. What do you get for intrinsic value? How does it compare to today's price?
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