How to Calculate a Stock's Fair Value Using DCF (Beginner-Friendly Guide)
- Sanzhi Kobzhan
- Apr 20
- 6 min read
Equity valuation refers to the stock target price calculation, which is the stock fair value based on forecasted company financials. By calculating the stock target price, analysts can make a conclusion on whether the stock is undervalued (the stock target price is above its current market price) or overvalued (the stock target price is below its market price). In this article, we will dive into the stock target price calculation, and I will provide you with a step-by-step guide on defining the stock fair value (target price) using the DCF valuation model.
Popular equity valuation models
When it comes to calculating the stock target price, there are three popular equity valuation models: the Discounted Cash Flow model (DCF), the Dividend Discount Model (DDM), and the Price-Income model (Multiplicators model). Investment analysts can use one of these models or combine them in their analysis, calculating the average price that they get from the three models. Each of these models has its own pros and cons. The DDM, for example, is easier, but it can only be used with companies that regularly pay dividends (for at least a couple of years). The Price-Income model is the easiest and fastest among the three, but it gives less accurate results since you assign the importance to each financial ratio. And finally, the DCF model is the most widely used model, but it takes time to compute, and you have to have a deeper understanding of a company’s cash flow structure in order to forecast it. You also have to make your own assumptions, which makes this model not one hundred percent accurate. But still, with the DCF, you can understand company risks better and come to an understanding of whether the stock is underpriced or overpriced.
How to Calculate a Stock's Fair Value Using DCF (Beginner-Friendly Guide)
The Discounted Cash Flow (DCF) model estimates a company's intrinsic value by forecasting its future Free Cash Flows (FCFs) and then discounting (dividing) them to the present using the Weighted Average Cost of Capital (WACC). This gives you the target price you can compare with the current market price.
Step-by-Step Guide to DCF Valuation
1. Forecast Free Cash Flow (FCF) for 5–10 Years
What is Free Cash Flow?
Free Cash Flow = Operating Cash Flow – Capital Expenditures
It represents cash the company can use for expansion, dividends, debt reduction, etc.
How to Forecast It:
You typically forecast 5–10 years based on historical data, your custom assumptions, or get the growth rate from financial endpoint providers.
Steps:
1. Get historical FCF from websites like Yahoo Finance or get a historical cash flow statement from the Cash Flow Statement API endpoint provided by the Financial Modeling Prep.
2. Choose a growth rate for future FCF based on:
- Past FCF growth, which you can get from the Cash Flow Statement Growth API endpoint
- Revenue and EBIT growth trends
- Industry outlook
- Analyst estimates (if available). You can search different stock analysis websites and see if analysts cover your chosen company.
3. Apply the growth rate to estimate future FCFs:
FCF for next year = FCF for current year × (1 + growth rate)
Example:
If the current FCF is $1 billion and expected to grow at 10%:
- Year 1 FCF = 1.00B × (1 + 10%) = $1.10B
- Year 2 FCF = $1.10B × (1 + 10%) = $1.21B
... and so on
2. Calculate Terminal Value (TV)
Terminal Value captures the value of cash flows beyond the forecast period.
Two Methods:
a) Perpetuity Growth Method (Gordon Growth Model):
TV = (FCF in final forecast year × (1 + terminal growth rate)) / (WACC - terminal growth rate)
Use a conservative growth rate (1%–4%), based on long-term GDP or inflation expectations.
b) Exit Multiple Method (less used in classic DCF):
Multiply the last year’s EBITDA or EBIT by an industry average exit multiple.
3. Calculate Discount Rate (WACC)
WACC = Weighted Average Cost of Capital
It represents the company’s average cost of financing from equity and debt.
WACC = (E/V × Re) + (D/V × Rd × (1 - Tc))
Where:
- E = Market value of equity
- D = Market value of debt
- V = E + D
- Re = Cost of equity (use CAPM model)
- Rd = Cost of debt
- Tc = Corporate tax rate
In simple terms, WACC is the weighted average cost that the company pays for attracting debt (through bonds or bank borrowings) and through issuing equity.
Re = Risk-free rate + Beta × (Market return – Risk-free rate)
Example:
- Risk-free rate = 4%
- Beta = 1.2
- Market return = 9%
Re = 4% + 1.2 × (9% – 4%) = 10%
The risk-free rate is the average rate of the US Treasury yield. Take yields of the US Treasuries of different maturities and calculate the average yield of those issues.
Beta is the stock risk in comparison to the market (S&P 500 if we talk about the US market). For example, a Beta of 2 indicates that your chosen stock is 2 times more volatile than the market. The Beta can be calculated using the formula or can be found on different websites like Yahoo Finance or Finviz.
4. Discount Future FCFs and Terminal Value to Present Value
Use the WACC to discount each year’s FCF:
Discounted FCF = FCF / (1 + WACC)^n
Where n is the year number (e.g., for year 2, n = 2). Discount each FCF individually and then sum them up.
For the Terminal Value:
Discounted TV = Terminal Value / (1 + WACC)^n
n = number of forecast years
5. Add the Present Values to Get Enterprise Value (EV)
Enterprise Value = Sum of discounted FCFs + Discounted Terminal Value
6. Calculate Equity Value
Equity Value = Enterprise Value – Net Debt
Net Debt = Total Debt – Cash
7. Calculate Fair Value Per Share (Target Price)
Target Price = Equity Value / Shares Outstanding
Assumptions You Need to Make
1. FCF Growth Rate (5–10 years): Based on company performance and macro outlook.
2. Terminal Growth Rate: Conservative long-term growth (e.g., 2%).
3. Discount Rate (WACC): Based on company’s risk and capital structure.
4. Market Return and Risk-Free Rate: Use Treasury yields and long-term market averages.
5. Shares Outstanding and Net Debt: Get latest numbers from the balance sheet.
Example (Simplified):
Let’s say:
- Current FCF = $1B
- Growth rate = 10%
- Terminal growth = 2%
- WACC = 9%
- Forecast period = 5 years
After projecting cash flows, discounting them, and calculating the terminal value, you find:
- Enterprise Value = $20B
- Net Debt = $2B
- Shares = 500M
Then:
Equity Value = $20B – $2B = $18B
Target Price = $18B / 500M = $36/share
By now you should have a clearer picture of how to calculate a stock's fair value (target price). If you want to dive deeper into stock target price calculation, you can read another article on the stock target price calculation where I provide a detailed guide with pictures and explain the process step by step. You can also try taking my stock market crash course where I provide video tutorials and share my Excel model on stock target price calculation. You will be able to download my model and use it in your analysis. Also, I have an amazing app called Stocks 2 Buy. It has the Stock Type screen—simply input the stock ticker, press the Analyze button, and you will get the stock growth potential (which is the difference between the stock target price calulated using the DCF model, and the market price). If the percentage is positive, then the stock is undervalued (trading cheap) and its target price is above its market price. The image from the app is below. where it shows the 27% growth for the ASML stock ticker (ASML Holding NV).
As you can see from the image above, the Stocks 2 Buy app not only calculates the stock growth potential (which is 27% in our example) but also shows the Piotrkowski score of 8, suggesting that the stock is very strong fundamentally, the dividend yield of 0.62%, suggesting a small dividend payout, and a stock return in the past 3 and 6 months. Based on those returns, you can understand how volatile the stock is and if it touched its local minimum. For example, a large price drop in the past 3 months, given a high Piotrkowski score and a good growth potential, may suggest that this undervalued stock is a value equity that has touched its local minimum, which can be considered a good buying opportunity.
Thank you for reading the article. Please keep in mind that there is no equity valuation model that is 100% accurate since you are using custom assumptions and making forecast and everything can change—for example, the company can change its business model, or the company’s cash flow may change, or the cost of money may increase, affecting the discount rate (WACC). That’s why it is also recommended to regularly recalculate the stock target price and update your model to reflect market changes. I hope this article was helpful. If you tried calculating the stock target price manually and have difficulties calculating it, you can write a comment on this article and we can discuss your issue and the result.
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