Ask Matt: See if stock is cheap like Buffett does

• Discounted cash flow analysis measures how much a company is worth
• DCF is a technique Warren Buffett uses to value companies
• The analysis can be done with a calculator or computer

USA TODAY markets reporter Matt Krantz answers a different reader question every weekday. To submit a question, e-mail Matt at mkrantz@usatoday.com.

Q: What is a discounted cash flow analysis and how can stock investors use it?

A: If you'd rather get a dollar today than a dollar in 20 years, you already understand the value of the discounted cash flow analysis for stock picking.

The discounted cash flow analysis, or DCF for short, is a common method used by fundamental analysts to measure how much a company is worth. A DCF looks at a company as a cash-generating machine. Math is used to measure how much that cash, if received today, would be worth. This value tells the investor if the current stock price means the stock is under- or overvalued.

It's the technique used by Warren Buffett to value companies. There are two main steps to a DCF analysis. First, the analyst must estimate how much cash the company is expected to generate not just this year, but many years from now. Making this estimate takes intimate knowledge of a company and its industry.

Next, the analyst must "discount" those estimated future cash flows. Using a variety of techniques, the analyst tries to come up with an interest rate that reflects both the time value of money and investment risk.

Investors in a risky company would demand a higher discount rate, while those in mature industries would apply a lower discount rate. These variables, coupled with math, provide a value of the company. If the current stock price is less than the present value of the company's future cash flows, it is considered cheap and investors might consider buying. If the current stock price, though, is greater than the value of the company's cash flows, it's expensive and may not be a good investment.

A discounted cash flow analysis can be done with the use of a computer or calculator. There are also websites that can help investors perform a discounted cash flow analysis on stocks, including NewConstructs.com and Trefis.com.