How to value a stock

Valuing a stock means estimating what a business is intrinsically worth — independent of what the market currently prices it at. When you find a gap between intrinsic value and market price, you've found an opportunity.

Step 1 — Understand the business

Before touching a single number, ask yourself: do I understand how this company makes money? Warren Buffett calls this staying within your circle of competence. You don't need to understand every business — but the ones you value, you should understand deeply.

Key questions: What does the company sell? Who are its customers? Does it have a durable competitive advantage (a "moat")? Is the industry growing or shrinking? Who is the management team?

Step 2 — Review the financial statements

Three documents tell most of the story:

Income Statement

Shows revenue, operating profit, and net income. Look for consistent revenue growth and expanding (or at least stable) profit margins over 3–5 years.

Balance Sheet

Shows what the company owns (assets) and owes (liabilities). Pay particular attention to net debt (total debt minus cash) — it directly affects equity value in a DCF model.

Cash Flow Statement

The most important statement for DCF valuation. Free cash flow (operating cash flow minus capital expenditures) is the raw fuel of intrinsic value. Companies that consistently generate strong FCF are the best candidates for DCF analysis.

Step 3 — Estimate future free cash flows

This is the hardest step — and the one most subject to error. A common approach:

• Start with the last 3 years of FCF and calculate a weighted average (giving more weight to recent years)
• Apply a growth rate for years 1–5 based on analyst consensus estimates
• For years 6–10, assume growth gradually reverts toward the industry average (mean reversion)
• Run a Bear, Base, and Bull scenario to bound your uncertainty

Be conservative. The biggest mistakes in DCF come from projecting hyper-growth indefinitely. Cap your near-term growth at 30% and be realistic about terminal growth (typically 2–3%, in line with long-run GDP).

Step 4 — Calculate the discount rate (WACC)

The Weighted Average Cost of Capital (WACC)reflects how risky the investment is. A higher WACC produces a lower intrinsic value (because future cash flows are worth less in today's dollars).

For most US large-cap stocks, WACC falls between 7% and 12%. High-quality mega-cap companies (Apple, Microsoft) sit at the lower end; smaller, more volatile companies at the higher end.

Step 5 — Run the DCF and calculate terminal value

Discount each year's projected FCF back to today using WACC. Then calculate the terminal value — the lump-sum value of all cash flows beyond year 10. A common approach blends two methods:

• Gordon Growth Model: Terminal Value = FCF₁₀ × (1 + g) / (WACC − g), where g = long-term growth rate
• Exit Multiple: Terminal Value = EBITDA₁₀ × Sector Multiple

Sum all discounted cash flows plus the discounted terminal value to get Enterprise Value. Subtract net debt, divide by shares outstanding, and you have your fair value per share.

Step 6 — Compare to the market price

If your calculated intrinsic value is significantly abovethe current stock price (a common threshold is 20–30% upside), the stock may be undervalued and worth deeper research. If it's below the market price, the stock may be overvalued — or your growth assumptions may be too conservative.

Always treat DCF output as a range, not a precise number. The Bear / Base / Bull scenarios show you the sensitivity of your valuation to different assumptions.

Key metrics to watch