Why do we value stocks? The answer is that valuing stocks helps us to know whether the market is undervaluing the stock or overvaluing the stock. Your decision to buy or sellthe stock will be based on this input. There are many methods of valuing a company but one of the more popular methods is the Discounted Cash Flow method (DCF). The DCF valuation method is simple and elegant, as we shall see later. The DCF stock valuation calculator is available in many websites but it is perhaps more important to understand the gist of the concept of DCF. In a nutshell, the DCF method projects the cash flows for the future and then discounts them to the present to get a present value. This present value is an approximation of the valuation of the company, to which many qualitative adjustments will be required.

Key components of DCF valuation methodology..

Remember, DCF works best in case of companies that have stable business models and are growing at a stable rate. Start-up firms, companies requiring huge capital outlays, companies with long gestation for profits cannot use the DCF method as it will distort the valuations.

The DCF valuation once calculated needs to be mugged with realism. If you get a valuation of 25X for a metals company, there is obviously something off the mark. You need to look at domestic and global benchmarks of P/E ratio and P/BV ratio to make a more reasonable call o the DCF valuation.

Finally, you need to understand margin of safety when it comes to DCF valuation. DCF is very data sensitive. A change in the growth or the cost of capital can make a huge impact n valuation. Hence it is safer to keep a margin of safety. For example, you can stipulate that a stock is underpriced only if the market price is at least 20% below the DCF valuation. That will give you a margin of safety and reduce your overall risk.

Many critics call DCF rear-view mirror valuation. But it is among the best working models available. As an investor you need to make the best of this method to get a hang of the stock.