What is DCF?
Discounted Cash Flow (DCF) analysis estimates the present value of a company based on its expected future cash flows. It is the theoretical foundation of almost all company valuation in professional finance, used by investment banks, private equity firms, and institutional asset managers worldwide.
Professor Damodaran at NYU Stern, widely considered the world's leading authority on valuation, calls DCF "the ultimate test of investing discipline" — it forces you to make explicit assumptions about every driver of value.
The Time Value of Money
The core principle of DCF is that SAR 1 today is worth more than SAR 1 in the future — because today's riyal can be invested to earn a return. Therefore, future cash flows must be "discounted" back to their present value.
Where CF is the future cash flow, r is the discount rate, and n is the number of years. The Khan Academy's time value of money series explains this concept clearly with worked examples and is free to access.
DCF: Step-by-Step
Step 1 — Project Free Cash Flow: Forecast the company's free cash flow for 5–10 years. Use the historical FCF as the base and apply a growth rate derived from revenue trends, margin expectations, and capital expenditure forecasts.
Step 2 — Choose a Discount Rate (WACC): The Weighted Average Cost of Capital (WACC) reflects the return investors require. A riskier business demands a higher discount rate. See the section below for how to calculate it.
Step 3 — Calculate Terminal Value: Beyond year 10, you assume the business grows at a stable "terminal growth rate" (typically 2–3%, close to long-term GDP growth). This is discounted back to today.
Step 4 — Sum All Present Values: Add the discounted cash flows for all years plus the discounted terminal value to get Enterprise Value. Subtract net debt to get equity value, then divide by shares outstanding for intrinsic value per share.
Understanding the Discount Rate (WACC)
Where E = equity, D = debt, V = total capital, Re = cost of equity, Rd = cost of debt.
The cost of equity is typically calculated using the Capital Asset Pricing Model (CAPM): Re = Risk-Free Rate + Beta × (Market Risk Premium). For TASI stocks, the risk-free rate is typically approximated by the Saudi Government Bond yield, available from SAMA. For global equity risk premia by country, Damodaran's country risk premium dataset is the standard source.
Terminal Value
Terminal value often accounts for 60–80% of total DCF value, which is why the terminal growth rate assumption is so critical. The two main methods:
| Method | Formula | When to Use |
|---|---|---|
| Gordon Growth Model | FCF × (1 + g) ÷ (WACC − g) | Mature businesses with stable growth |
| Exit Multiple | EBITDA × Industry EV/EBITDA Multiple | When reliable comparable transactions exist |
Never use a terminal growth rate above long-term nominal GDP growth. IMF World Economic Outlook provides long-term GDP growth forecasts by country, a useful sanity check.
A Worked Example
Assume a company generates SAR 500M in FCF today, growing at 10% for 5 years, then 3% in perpetuity. WACC = 9%. Here are the projected and discounted cash flows:
| Year | FCF (SAR M) | Discount Factor (9%) | Present Value |
|---|---|---|---|
| 1 | 550 | 0.917 | 504 |
| 2 | 605 | 0.842 | 509 |
| 3 | 666 | 0.772 | 514 |
| 4 | 732 | 0.708 | 518 |
| 5 | 805 | 0.650 | 523 |
| Terminal Value | 805 × 1.03 ÷ (0.09 − 0.03) | = SAR 13,819M | 8,982 |
| Enterprise Value | SAR 11,550M |
Subtract net debt (say SAR 1,200M) → Equity Value = SAR 10,350M. Divide by 200M shares → Intrinsic value = SAR 51.75 per share. If the stock trades at SAR 40, the margin of safety is 23% — potentially a compelling buy.
TruePrice.Cash's DCF engine automates this calculation for every TASI stock, pulling live financial data and applying sector-appropriate WACC estimates.
DCF Limitations & Sensitivity
DCF is highly sensitive to input assumptions. Changing the WACC by 1% or the terminal growth rate by 0.5% can change the intrinsic value by 20–30%. This is not a weakness unique to DCF — it reflects genuine uncertainty about the future.
Always run a sensitivity table — a matrix showing intrinsic value across a range of WACC and growth rate combinations. This gives you a range of fair values, not a false point estimate. Excel templates for this are available free at Wall Street Prep's DCF model guide.
The greatest investors acknowledge that DCF provides a framework for disciplined thinking, not a precise answer. As Buffett noted, in his 1992 letter, it's better to be approximately right than precisely wrong.