How to Estimate Intrinsic Value: A Step-by-Step DCF Example

"Intrinsic value" sounds like something only professional analysts can calculate. It is not. The idea is the one any small business owner already uses: a business is worth the cash it will put in your pocket over its life, and a euro you receive in ten years is worth less than a euro today. A discounted cash flow (DCF) model simply writes that idea down as arithmetic.

In this article I go through a full DCF one step at a time, with a made-up company and numbers you can repeat in the DCF Calculator. You do not need a spreadsheet.

Step 1: Find the free cash flow

Free cash flow (FCF) is the cash a business has left after paying for everything it needs to keep running and growing:

Both numbers are in the cash flow statement of the annual report. Use free cash flow rather than profit because profit includes accounting items that are not cash, and because a company that must constantly reinvest everything it earns has less to give its owners than its profit suggests.

Two practical tips. First, look at five to ten years, not one: a single year can be unusually good or bad. Use an average or a "normal" year. Second, decide whether you work per share or for the whole company. Per share is easier, because you can compare the result directly with the share price.

Our example company, Harbour Tools Oy, has had free cash flow of about €2.00 per share in a normal year.

Step 2: Choose a growth rate for the next ten years

This is where most DCF models go wrong, almost always in the optimistic direction. Look at how fast free cash flow, sales and earnings have actually grown in the past, then be more conservative, not less. Very few companies grow faster than 10% a year for a whole decade.

A useful sanity check is the Rule of 72: divide 72 by the growth rate to see how many years it takes to double. At 6%, cash flow doubles in about 12 years. At 15% it doubles in under 5 years, and doubles again in another 5. Ask yourself whether that is believable for this business.

For Harbour Tools, I use 6% a year for years 1 to 10.

Step 3: Choose a terminal growth rate

No company grows fast forever. After year 10 the model assumes a slow, steady rate for all future years. This rate should be close to long-run inflation or economic growth, usually 2–3%. If you set it higher than the economy can grow, you are saying the company will eventually become larger than the economy, which is impossible.

For Harbour Tools, I use 2%.

Step 4: Choose a discount rate

The discount rate is the return you require for taking the risk. It turns future euros into today's euros. A simple and honest approach is to use the return you could reasonably expect elsewhere: many private investors use 8–10% for stable, established companies and 12% or more for riskier ones. The higher the risk, the higher the rate, and the lower the value.

For Harbour Tools, I use 9%.

Step 5: Project and discount ten years of cash flow

Now grow the cash flow 6% a year and divide each year's amount by (1 + 9%) to the power of the year number:

Step 6: Add the terminal value

Everything after year 10 is captured by the terminal value, using the Gordon growth formula:

Notice that the terminal value is more than half of the total. That is normal, and it is also the biggest weakness of every DCF: most of the value depends on what happens far in the future.

Step 7: Add it up and compare with the price

Intrinsic value = €17.21 + €22.05 = €39.26 per share.

If Harbour Tools trades at €26.00, the share looks about a third cheaper than our estimate. But do not stop here. One number gives a false sense of precision.

Step 8: Test your assumptions

A sensitivity table shows how the value changes when growth and discount rate change. Here is Harbour Tools with terminal growth fixed at 2%:

The range runs from about €29 to €54. That spread is the honest answer: the business is probably worth somewhere in the €30s or €40s, and nobody can say exactly where. A value investor focuses on the cautious corner of the table. Here even the most cautious case, €29.44, is above the €26.00 price, but only by about 12%. That is the kind of thin cushion I discuss in the article on margin of safety.

Cross-check with simpler methods

Never trust a DCF alone. Compare it with quicker yardsticks:

• The Graham Number for Harbour Tools (EPS €2.10, book value €14.00 per share) is about €25.72, close to today's price. Graham's conservative test says the share is fairly priced, not cheap.
• The P/E ratio is 26.00 ÷ 2.10 ≈ 12.4 and P/B is 26.00 ÷ 14.00 ≈ 1.9. Reasonable, but above Graham's classic limit of 1.5 times book value.

When different methods disagree, believe the cautious ones until you have a good reason not to.

Five DCF mistakes to avoid

1. Using one great year as the starting point. Use a normal year or an average.
2. Growth that is too high for too long. Check it with the Rule of 72.
3. A terminal growth rate above 3%. No company outgrows the economy forever.
4. A discount rate that is too low. A low rate inflates the value of every distant euro.
5. Treating the answer as exact. A DCF gives a range, not a price target.

Summary

A DCF is not magic and not only for professionals. It is a structured way to ask four questions: how much cash does the business produce, how fast can that grow, for how long, and what return do I need? Answer them conservatively, look at the range rather than a single number, and buy only when the price sits well below the cautious end of that range.

Try your own numbers in the DCF Calculator, then check the result with the Margin of Safety Calculator.

This article is for education only and is not investment advice. Harbour Tools Oy is a fictional company used for illustration. Figures are rounded.