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For most people, discounted cash flow (DCF) valuation seems like a form of financial black art, best left to Ph.D.s and Wall Street technical wizards. DCF intricacies do involve complex math and financial modeling, but if you understand the basic concepts behind DCF, you can perform "back-of-the-envelope" calculations to help you make investment decisions or value small businesses. In this article, we'll review a few practical applications.

DCF Usages
Let's begin with a brief overview. DCF is a valuation method that can be used for privately held companies. It projects a series of future cash flows, EBITDA or earnings and then discounts for the time value of money, typically using the company's own weighted average cost of capital (WACC) over a period of five to 10 years. The sum of all future discounted flows is the company's present value. Professional business appraisers often include a terminal value at the end of the projected earnings period, and they also may apply discounts for small-company risk, lack of liquidity or shares representing a minority interest in the company.

An Acid Test for Valuing a Public Stock
DCF is a blue-ribbon standard for valuing privately held companies; it can also be used as an acid test for publicly traded stocks. Public companies in the U.S. may have P/E ratios (determined by the market) that are higher than DCF. This is especially true of smaller, younger companies with a high cost of capital and uneven or uncertain earnings or cash flow. But it also can be true of large, successful companies with astronomical P/E ratios.

For example, let's do a simple DCF test to check whether Apple (Nasdaq:AAPL) stock was fairly valued at a given point in time. During June of 2008, Apple had a market capitalization of $150 billion. The company was generating operating cash flow of around $7 billion per year and we'll assign a WACC of 7% to the company, because it is financially strong and can raise equity and debt capital inexpensively. We'll also assume that Apple can increase its operating cash flow by 15% per year over the 10-year period, a somewhat aggressive assumption because few companies are capable of sustaining such high growth rates over lengthy periods. On this basis, DCF would value Apple at a market capitalization of $106.3 billion, 30% below its stock market price at the time. In this case, DCF provides one indication that the market may be paying too high of a price for Apple common stock. Smart investors might look to other indicators, such as inability to sustain cash flow growth rates in the future, for confirmation.