The classic work of John Burr Williams (see the models section at theory ) is the basis for the development of most equity valuation models, and his work is here referred to as the DCF Model rather than the narrower misleading name of Dividend Discount Model or DDM.
For academic models of equity valuation, see Investments by Brodie, Kane and Marcus in General Books, or go to textbook models. For less academic approaches to firm valuation, see Damodaran on Valuation in Special Books, or go to his practical modelsof equity valuation. For a practical firm valuation model, see the McKinsey model tutorial with an example company valuation and downloads in a working paper at the Stockholm School of Economics. The McKinsey approach is the subject of the book titled Valuation by Tom Copeland et al in General Books.
The general model can be expressed verbally, mathematically, and graphically.
Thus, in words:
1. If you commit your cash to a particular investment opportunity, then what cash can you expect to get out of it in return? What is your reward for abstinence and risk-taking?
2. What are the estimated net cash flows attributable to this proposed investment; i.e., what are the expected dividend distributions and the future terminal selling price?
3. What is the present value of these net cash flows, discounted at an appropriate rate of interest? This is the intrinsic economic value of the equity investment.
4. What is the margin of safety, both in dollars and in percentage? Is the intrinsic value per share of common stock greater than the stock market asking-price quotation by an amount sufficiently compelling to justify a long-term commitment to this particular investment?
Mathematically, the DCF model can be expressed both in an abstract standard form for the general case and in many concrete forms for simplifying special cases. Conceptually, the DCF Model is like an ideal of Plato which manifests itself in different empirical forms. We refer to these empirical forms types of the DCF Model. In all forms, the net present value of the investment, i.e., its intrinsic economic value, is equated with the sum of the products of each net cash flow and its discount rate. After intrinsic value has been estimated from fundamental data, it can be expressed in terms of earnings, book value, dividends, sales, cash flow, or other accounting measures, but this is not necessary.
Graphically, the model can be expressed in two dimensions as a horizontal time line with vertical bars showing positive and negative net cash flows, above and below the line respectively, from the date of your investment at time zero to the date of your future sale at the end of your horizon for this investment.