Discounted cash flow method of valuation can be defined as the method under which the intrinsic value of an asset can be found based on its fundamentals. Intrinsic value of an asset can be defined as the present value of the future cash flow of the company. To calculate discounted cash flow one needs to know what will be future cash flows of the company and also weighted average cost of capital to discount those future cash flows. It can be calculated as –
DCF = CF1/(1+r) for first year + CF2/(1+r) for second year + CFn/(1+r) for n years
CF = Cash Flow
r = Discount rate (WACC)
If on the basis of above estimate the value of a company or asset is higher than its current cost than it is considered as profitable investment otherwise not. So in simple words it a method which tells an investor who is looking to buy into the stocks of a company whether the value of stock is higher or lower than what it should be and hence investor can take a decision either to buy if the stock is undervalued or sell if it is overvalued according to discounted cash flow method of valuation.
However only this method cannot be relied on while taking a decision regarding whether to buy or sell a stock but it certainly forms the base or starting point for any investor to take any future decisions regarding the stock in which he or she is interested in.