Nvidia and AI: using a DCF model for valuation

Hello. I'm Dr. Michael McDonald. I'm an associate professor of finance at Fairfield University in Fairfield, Connecticut. Today, I'd like to show you how you can use a DCF model for valuation. Specifically, we're going to focus on the case of Nvidia and AI.

What is a discounted cash flow or DCF model? A DCF model is a financial valuation method which is used to estimate the intrinsic value of a company or asset. It calculates the present value of a firm's expected future cash flows. The idea here is that $1 today is worth more than $1 in the future. That's a core principle of time value of money. DCF models are used by investors, analysts and corporate finance professionals to determine whether a stock or a firm is undervalued or overvalued.

There are several key components in a DCF model. We start with forecasting the free cash flow for the firm. We need to figure out what future cash flow is available to the firm after expenses and reinvestments. Next, we have to determine our discount rate or WACC. This WACC or weighted average cost of capital is the required rate of return when investing in the firm, and it's a combination of the required rate of return for debt and the required rate of return for equity in the firm. Next, we have to determine the terminal value or horizon value of the firm. This is the estimated value of the company beyond the explicit forecast period. Then finally, we have to do a present value calculation. Future cash flows are discounted back to today's value and summed up in order to figure out the value of the underlying entity.