Concept: Discounted Cash Flow (DCF)
DCF is a valuation method that calculates what a business is worth today by estimating all the cash it will produce in the future and discounting those cash...
What it is
DCF is a valuation method that calculates what a business is worth today by estimating all the cash it will produce in the future and discounting those cash flows back to present value. It's the gold standard of fundamental valuation — the most theoretically correct method, though also the most assumption-sensitive.
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"DCF matlab — company aage kitna cash banayegi, woh sab aaj ki value mein convert karo. Yeh company ki sacchi keemat hai. Baaki sab shortcuts hain."
The core idea: ₹100 tomorrow ≠ ₹100 today
Money has a time value. ₹100 received today is worth more than ₹100 received in 5 years because:
- You could invest today's ₹100 and earn returns
- Inflation erodes future purchasing power
- Future cash is uncertain — it may not materialise
Present Value = Future Cash Flow / (1 + Discount Rate)^n
The DCF model structure
The formula
$$\text{Intrinsic Value} = \sum_{t=1}^{n} \frac{FCF_t}{(1+WACC)^t} + \frac{TV}{(1+WACC)^n}$$
Where:
- $FCF_t$ = Free Cash Flow in year t
- $WACC$ = Weighted Average Cost of Capital (discount rate)
- $TV$ = Terminal Value (value of all cash flows beyond year n)
- $n$ = forecast period (typically 10 years)
Step-by-step example: Indian IT company
Let's value a hypothetical IT company:
Assumptions:
- Current FCF: ₹5,000 Cr
- Growth rate (Years 1-5): 15%
- Growth rate (Years 6-10): 10%
- Terminal growth rate: 5%
- WACC: 11%
| Year | Growth | FCF (₹ Cr) | Discount Factor | PV (₹ Cr) |
|---|---|---|---|---|
| 1 | 15% | 5,750 | 0.901 | 5,180 |
| 2 | 15% | 6,613 | 0.812 | 5,367 |
| 3 | 15% | 7,604 | 0.731 | 5,559 |
| 4 | 15% | 8,745 | 0.659 | 5,762 |
| 5 | 15% | 10,057 | 0.593 | 5,964 |
| 6 | 10% | 11,062 | 0.535 | 5,914 |
| 7 | 10% | 12,169 | 0.482 | 5,864 |
| 8 | 10% | 13,386 | 0.434 | 5,812 |
| 9 | 10% | 14,724 | 0.391 | 5,757 |
| 10 | 10% | 16,197 | 0.352 | 5,702 |
Sum of PV of cash flows: ₹56,881 Cr
Terminal Value: $TV = \frac{16,197 \times 1.05}{0.11 - 0.05} = ₹2,83,449 \text{ Cr}$
PV of Terminal Value: ₹2,83,449 × 0.352 = ₹99,774 Cr
Enterprise Value: ₹56,881 + ₹99,774 = ₹1,56,655 Cr
If Net Debt = ₹2,000 Cr, Shares = 500 Cr:
Equity Value = ₹1,54,655 Cr → Intrinsic Value per share = ₹3,093
WACC: The discount rate
$$WACC = \frac{E}{E+D} \times K_e + \frac{D}{E+D} \times K_d \times (1-t)$$
For most Indian non-financial companies, WACC typically ranges:
- Conservative: 12-14%
- Moderate: 10-12%
- Aggressive: 8-10%
Rule of thumb for India: Use 10-12% for established companies, 12-14% for risky/small companies.
Terminal Value: The biggest assumption
Terminal Value often = 60-70% of DCF
This is the most debated part. Two approaches:
Gordon Growth Model: $TV = \frac{FCF_{n+1}}{WACC - g}$
- Use terminal growth rate of 4-6% (should never exceed GDP growth)
- Risk: small changes in g have massive impact
Exit Multiple: $TV = EBITDA_{year10} \times Exit Multiple$
- Use sector-median EV/EBITDA as exit multiple
- More practical; less sensitive to growth rate assumption
When DCF works and when it doesn't
| Works well for | Does NOT work for |
|---|---|
| Stable cash flow businesses (IT, FMCG) | Deeply cyclical companies (steel, shipping) |
| Companies with visible earnings trajectory | Loss-making companies with no cash flow |
| Mature businesses with long track record | Banks/NBFCs (use residual income model instead) |
| Companies you understand deeply | Companies with unpredictable business models |
Common mistakes
Mistakes to avoid
- Garbage in, garbage out — Your DCF is only as good as your growth assumptions. 2% error in growth rate = 30-40% error in value
- Terminal growth > GDP — No company grows faster than the economy forever. Cap at 5-6% for India
- Too low discount rate — India ≠ USA. Don't use 8% WACC for Indian companies unless you have a very good reason
- Not doing sensitivity analysis — Always vary WACC (±2%) and terminal growth (±1%) to see value range
- Ignoring reinvestment needs — FCF must account for maintenance capex + working capital growth. Don't just use PAT as a proxy
- False precision — "₹4,237.42 per share" is nonsense. Report as a range: ₹3,500–5,000
The anti-DCF approach (sanity check)
After running a DCF, do a reverse DCF: What growth rate is the CURRENT market price implying?
If market price = ₹4,500 and your DCF says ₹3,100, the market is pricing in ~20% growth for 10 years. Is that realistic? If not, the stock is overvalued despite growth.
Related concepts
- Intrinsic Value — DCF is the primary method to estimate intrinsic value
- Margin of Safety — Buy only when market price is significantly below DCF value
- Compounding — Companies that compound FCF are ideal DCF candidates