ForecastingStocks

Let us value a small company with a complete, if simplified, DCF. The method has three parts: project the cash flows, value the years beyond the projection (the terminal value), and discount everything to today.

Step 1 — project free cash flow

We forecast free cash flow for five years. Suppose it starts at 100 and grows 10% a year:

Year 1   100
Year 2   110
Year 3   121
Year 4   133
Year 5   146

Step 2 — the terminal value

We cannot forecast forever, so after year 5 we assume cash flow grows at a slow, perpetual rate g (say 3%). The Gordon growth formula gives the value of all cash beyond year 5, expressed as of year 5:

Terminal value = FCF year5 x (1 + g) / (r - g)

With r = 10% and g = 3%:

Terminal value = 146 x 1.03 / (0.10 - 0.03) = 150 / 0.07 = 2,149

Step 3 — discount everything to today

Discount each year's cash flow, and the terminal value, back at r = 10%:

Year 1   100 / 1.10^1 =  90.9
Year 2   110 / 1.10^2 =  90.9
Year 3   121 / 1.10^3 =  90.9
Year 4   133 / 1.10^4 =  90.8
Year 5   146 / 1.10^5 =  90.7
Terminal 2,149 / 1.10^5 = 1,334.5
-------------------------------------
Enterprise value      = 1,788.7

Step 4 — to a per-share value

Subtract net debt to get equity value, then divide by shares. With net debt 200 and 100 shares:

Equity value   = 1,788.7 - 200 = 1,588.7
Value per share = 1,588.7 / 100 = 15.89

If the share trades below 15.89, the DCF says it is undervalued. Notice how much weight the terminal value carries (1,334 of 1,789) — that sensitivity is the model's great weakness, which the final chapter addresses.