Forecasted free cash flows (operating profit + depreciation + amortization of goodwill – capital expenditures – cash taxes – change in working capital) are discounted to a present value using the company’s weighted average costs of capital. DCF analysis shows that changes in long-term growth rates have the greatest impact on share valuation. Investors can also use the DCF model as a reality check. Instead of trying to come up with a target share price, they can plug in the current share price and, be working backward, calculate how fast the company would need to grow to justify the valuation. The lower the implied growth rate, the better – less growth has therefore already been “priced into” the stock
The dividend discount model is a more conservative variation of discounted cash flows, that says a share of stock is worth the present value of its future dividends, rather than its earnings. The dividend discount model can be applied effectively only when a company is already distributing a significant amount of earnings as dividends. But in theory, it applies to all cases since even retained earnings should eventually turn into dividends. That’s because once a company reaches its “mature” stage it won’t need to reinvest in its growth, so management can begin distributing cash to the shareholders. (Plan “B” would be for the CEO to pursue some insane acquisition, just to gratify his bloated ego.) As Williams puts it,
If earnings not paid out in dividends are all successfully reinvested… then these earnings should produce dividends later.