Value any Stock

As this is an equity DCF valuation, it should use free cash flow to equity (FCFE), rather than free cash flow to the firm (FCFF or unlevered free cash flow). Strictly speaking, FCFE equals i) operating cash flow minus ii) capital expenditure required to sustain growth plus iii) net borrowings minus iv) preferred dividends, although we use operating cashflow minus total capital expenditure as a proxy for FCFE.

For stable companies, the current year cashflow figure may suffice, or it may be better to use an average of several years' cashflows if cashflows are more volatile. To smooth out volatility, we employ a simple average of both values.

Growing or recovering companies can sustain above average growth rates in the short term. Very high growth rates tend to be unsustainable over long periods of time. Add several (declining) growth periods for a more realistic valuation.

The terminal growth rate is the permanent state of growth that the company can achieve once it's fast growth period is over. Most companies will tend towards growing earnings in line with long term trends of inflation (around 3%). Truly great companies can sustain higher permanent growth rates.

The Discount Rate can be thought of as the interest rate you demand for taking on the risk of owning the stock. The lower the discount rate the more confidence shown in future cashflows. Blue Chip discount rates should be 9-10%, Mid Caps 11-12% and small caps or volatile stocks 13-15%.