Step 2: How to Know If a Stock Is Undervalued (The Value Investor’s Way)
Step 2: Assessing whether a great company is selling at a good price
In our last post, we shared Step 1 of our process: how to identify a great company — one with strong financials, high margins, and a durable edge.
But finding a great business isn’t enough.
Step 2 is where value investors separate from the crowd:
Is this great company selling at a great price?
In this post, we’ll walk through how we answer that question — using simple valuation tools like the Reverse DCF method, common-sense assumptions, and a margin of safety.
The Reverse DCF helps us figure out what level of growth the market is pricing in — and whether we think that’s realistic.
We’ll also explain why we prefer this method over classic DCF models and other traditional valuation techniques — and how it keeps our analysis grounded in reality.
Is This Company Selling at a Good Price?
To determine if the company is selling at a good price, we’ll use a reverse DCF (Discounted Cash Flow) technique.
Unlike the classic DCF method, where you forecast future cash flows and discount them to the present value, the reverse DCF starts with the current price of the stock and calculates what the company's future growth would need to be in order to justify that price.
Once the implied growth rate is calculated, you can compare it to the company's historical performance, industry trends, and your own expectations for future growth.
If the implied growth rate is much higher than what seems reasonable or achievable, the stock may be overvalued. Conversely, if the implied growth rate is low compared to expectations, the stock could be undervalued.
This method is particularly useful for assessing whether a stock is priced correctly based on the market’s expectations of future performance, without relying on your own growth forecasts. It allows you to critically evaluate the current price and understand if the market is overestimating or underestimating the company’s future potential.
Why Reverse DCF Is Better Than Classic DCF and Other Traditional Valuation Methods
We don’t rely on classic DCF models or other traditional valuation techniques for a simple reason:
they’re too dependent on assumptions.
Classic DCF requires you to forecast future revenue growth, margins, cash flows, and discount rates — often 5 to 10 years out. But the further out you go, the less reliable those assumptions become. Small changes in your inputs can dramatically change the final valuation.
That kind of precision gives a false sense of accuracy.
The Reverse DCF flips the process: instead of guessing future growth, it asks,
“What growth does the current stock price already assume?”
Then we evaluate whether that assumption makes sense, based on real-world data — not optimistic forecasts.
That’s why we prefer the Reverse DCF.
It keeps us grounded, realistic, and focused on expectations already priced in by the market — not just what we hope the company will achieve.