Walk Me Through a DCF: A Simple Guide to Discounted Cash Flow Valuation

Are you curious about how professional investors decide whether a stock might be one of the best undervalued stocks to buy now? One of the most popular tools is the Discounted Cash Flow (DCF) model. In this article, I'll walk you through a DCF step by step. By the end, you'll see how the Advanced DCF API from Financial Modeling Prep can make this process more efficient. Let's get started!

What Is a DCF?

A DCF is all about estimating a company's fair value based on the money (cash flows) it might generate in the future. By discounting these future cash flows back to today, we can see if the stock price is trading above or below what it's fundamentally worth. If the current market price is lower than the DCF-derived price, it could be a hidden gem.

Step 1: Forecast the Free Cash Flows (FCF)

The process often starts with projecting Free Cash Flows (FCF) for a certain number of years (typically 5 to 10). FCF is the cash left over after all business costs—such as operating expenses, taxes, and capital expenditures—are covered. It's a critical measure because it tells you how much money is truly available for investors.

- Identify Revenue and Growth: Estimate sales (revenue) based on the company's past performance and future outlook.

- Deduct Operating Costs and Taxes: Get to Earnings Before Interest and Taxes (EBIT), then account for taxes.

- Adjust for Depreciation, Amortization, and CapEx: Add back non-cash expenses (depreciation/amortization) and subtract capital expenditures.

- Consider Working Capital Changes: Changes in receivables, payables, and inventories can increase or reduce cash flow.

When using the Advanced DCF API from Financial Modeling Prep, you'll see fields like EBIT, depreciation, and capitalExpenditure. These help you calculate or confirm the free cash flow figure.

> Tip: If you're halfway through a fiscal year, you might adjust your model to account for the partial period.

Step 2: Determine the Discount Rate (WACC)

The next step is figuring out the right discount rate, often called the Weighted Average Cost of Capital (WACC). This rate tells you how much return investors expect for taking on the risk of putting money into the company.

- Cost of Equity: Derived using models like the Capital Asset Pricing Model (CAPM). It incorporates the risk-free rate, beta, and market risk premium.

- Cost of Debt: Based on the interest rate the company pays on its loans or bonds, adjusted for taxes.

- Capital Structure Weights: How much of the company is financed by debt versus equity?

In the Advanced DCF API data, you'll see fields like costOfEquity, costOfDebt, and equityWeighting. The output often includes a single wacc value, which you apply to discount future cash flows.

Step 3: Calculate the Terminal Value

Because companies don't just vanish after five or ten years, we need a Terminal Value (TV) to capture all cash flows beyond the forecast period. A common method is the perpetuity growth approach, which uses a long-term growth rate (e.g., 2%-4%).

- TV Formula (simplified):

Terminal Value = (Final Year FCF * (1 + Long-Term Growth Rate)) / (WACC - Long-Term Growth Rate)

In the API data, you'll spot a field called longTermGrowthRate that feeds directly into this calculation. You might also see a final figure for terminalValue for the last forecast year.

Step 4: Discount All Cash Flows to Present Value

Now, discount each year's FCF (plus the Terminal Value) back to today using the WACC.

- Present Value of a Future Cash Flow:

Present Value = (FCF in Year n) * [ 1 / (1 + WACC)^n ]

- Sum Them Up: The total of all these discounted amounts is the Enterprise Value (EV).

The Advanced DCF API often shows an intermediate total like sumPvUfcf (present value of the projected free cash flows) plus the presentTerminalValue for the terminal portion.

Step 5: Get to Equity Value Per Share

Finally, convert the Enterprise Value into Equity Value by subtracting net debt (total debt minus cash) and then dividing by the number of fully diluted shares outstanding.

- Equity Value = Enterprise Value - Net Debt

- Fair Value Per Share = Equity Value ÷ Shares Outstanding

In the JSON output, you'll see equityValuePerShare. For example, Apple's (`AAPL`) data might show a DCF-derived fair value around $132.30 per share. If the market price is below $132.30, that suggests potential undervaluation.

Watch my youtube video for practical stock fair value calculation using the DCF valuation model.

Common DCF Mistakes to Avoid

1. Forgetting the Big Picture: DCF is about future cash flows. Don't get lost in the math and ignore the broader business story.

2. Unrealistic Growth Rates: Small changes in growth or discount rates can make a huge difference.

3. Mixing Up FCFF and FCFE: FCFF is for the entire firm, FCFE is just for equity holders. Know which one you need.

4. Ignoring Mid-Year Conventions: Adjust your model for timing if you're mid-year.

5. Overlooking Sensitivity Analysis: Test different assumptions to see how the valuation changes.

6. Not Considering Industry Cycles: High volatility or cyclical industries may require more nuanced models.

Why Use the Advanced DCF API?

The Advanced DCF API from Financial Modeling Prep simplifies the entire process:

- It provides revenue, EBITDA, EBIT, depreciation, capitalExpenditure, and more—ideal for building or checking your FCF calculations.

- It includes WACC, cost of equity, and cost of debt to speed up your discount rate estimations.

- It shows terminalValue, enterpriseValue, netDebt, and the final equityValuePerShare—giving you a complete picture of the fair valuation in seconds.

All of this data ensures you can quickly spot whether a company is trading below its DCF-derived fair value, hinting that it could be one of the best undervalued stocks to buy now.

By following this five steps—forecasting cash flows, determining the WACC, calculating the terminal value, discounting to present value, and deriving the equity value—you'll have a solid framework for evaluating whether a stock is under- or over-valued.

When combined with real-world data, such as that from the Advanced DCF API by Financial Modeling Prep, you can quickly cut through guesswork and arrive at a fair value per share. If that fair value is higher than the current market price, you might just have found one of the best undervalued stocks to buy now for your portfolio.

Using a DCF is both an art and a science. Master the fundamentals, stay aware of potential pitfalls, and let the Advanced DCF API handle the heavy lifting for you—so you can focus on finding your next great investment opportunity.