If you've ever thumbed through a stock analysts' report, you will have probably come across a stock valuation technique called discounted cash flow analysis, or DCF for short. DCF entails forecasting future company cash flows, applying a discount rate according to the company's risk, and coming up with a precise valuation or "target price" for the stock.

The trouble is that the job of predicting future cash flows requires a healthy dose of guesswork. However, there is a way to get around this problem. By working backwards - starting with the current share price - we can figure out how much cash flow the company would be expected to make in order to generate its current valuation. Depending on the plausibility of the cash flows, we can decide whether the stock is worth its going price.

DCF Sets Target Prices
There are basically two ways of valuing a stock. The first, "relative valuation" involves comparing a company with others in the same area of business, often using a price ratio such as price/earnings, price/sales, price/book value and so on. It is a good approach for helping analysts decide whether a stock is cheaper or more expensive than its peers. However, it's a less reliable method of determining what the stock is really worth on its own.

As a consequence, many analysts prefer the second approach, DCF analysis, which is supposed to deliver an "absolute valuation" or bona fide price on the stock. The approach involves explaining how much free cash flow the company will produce for investors, over, say, the next 10 years, and then calculating how much investors should pay for that stream of free cash flows based on an appropriate discount rate. Depending on whether it is above or below the stock's current market price, the DCF-produced target