Discounted Cash Flow (DCF) Valuation

Imagine you are offered a small dairy in your town. You do not care what the dairy across the road sold for. You care about one thing: how much cash will this dairy put in my hands over the years I own it, and what is that worth to me today?

That is a DCF. You estimate the cash the business will generate, you adjust each amount for when you will receive it, and you add them up. The result is called the intrinsic value: an estimate of what the business is worth from its own cash, not from the mood of the market.

The method has two parts. The first is a forecast of cash for a number of years. The second is a single figure that stands for everything after the forecast ends, called the terminal value. Both depend on judgement. Neither is a fact. That is the key thing to hold on to through the rest of this topic.

Suppose someone promises you ₹100 a year from now. Would you swap it for ₹100 in your hand today? Most people would not, for two reasons. First, the ₹100 today could sit in a fixed deposit and earn interest. Second, the promise may not be kept. Both reasons say the same thing: a distant rupee is worth less than a near one.

If your money can earn 12 per cent a year with similar risk, then ₹100 a year from now is worth ₹100 ÷ 1.12 = ₹89.3 today. ₹100 in two years is worth ₹100 ÷ 1.12 ÷ 1.12 = ₹79.7. Each extra year takes off another slice. By year five the same ₹100 is worth only about ₹56.7.

This is exactly how a loan works in reverse. When a bank gives you a home loan, the EMIs you pay over twenty years add up to far more than the amount borrowed, because time has a price. Discounting is that price, applied backwards.

Every DCF, from a school exercise to a large research report, follows the same order. Knowing the order helps you spot where a report has made its biggest choices.

Start from the business, not the spreadsheet. Ask how fast sales can grow, what margin the business can keep, how much tax it pays, and how much it must spend on machines and stock to support that growth. A kirana that wants to double its sales must buy more stock and maybe rent a bigger shop; the cash it keeps is what is left after that spending.

The usual measure is free cash flow to the firm (FCFF): the cash available to both lenders and owners before any interest is paid. A simple version uses figures from the annual report: operating profit after tax, plus depreciation, minus capital expenditure, minus any increase in working capital. The cash flow statement topic and the working capital topic in this Academy show where each of those lines comes from.

Two habits keep a forecast honest. Tie every growth rate to something you can name: an order book, a capacity that is already built, a market that is not yet reached. And check that the margin you assume is one the business has earned before, or that you can explain why it will change.

The discount rate answers: what return must this business earn to be worth the risk? Money in a business comes from two places, and each has a cost. Owners expect a return for taking the risk of ownership. Lenders charge interest. Blend the two, weighted by how much of the funding each supplies, and you get the weighted average cost of capital (WACC).

Interest is a cost that reduces the company's tax bill, so the lenders' cost is counted after tax. In our illustration, 10 per cent interest with a 25 per cent tax saving costs the company 7.5 per cent.

The owners' required return cannot be looked up. It is an estimate, usually built from the return on a safe government bond plus a payment for the extra risk of shares. Different analysts reach different answers, and you should treat any figure they quote as an opinion. Rates change over time, so a real analysis needs the latest 10-year government bond yield, quoted with its date. The Clearing Corporation of India (CCIL) publishes indicative G-Sec yields by tenor on its website (ccilindia.com, page "Tenorwise Indicative Yields"); the RBI also reports G-Sec yields. The rates in this topic are teaching values only, and no current yield is stated here.

Take Ganga Speciality Ltd, an illustrative company and not a real one. Suppose its free cash flow is ₹100 crore in year 1 and grows 10 per cent a year for five years. The discount rate is 12 per cent. Each year's cash is multiplied by 1 ÷ 1.12 raised to the year number.

Read the last column: the cash grows every year, but the present value shrinks slightly, because the discount bites harder than the 10 per cent growth in the early years of this forecast. The five years together are worth ₹430.8 crore today.

A business does not stop in year 5. If you valued only the five forecast years, you would treat a going concern as if it closed down. The terminal value stands in for every year after the forecast.

The most common method assumes the cash grows at a steady rate for ever after year 5. The rate must be lower than the discount rate, or the formula breaks. By common valuation practice it is also kept small, at or below the long-run growth of the economy (a convention, not a rule; needs verification against a cited valuation text). In our illustration it is 4 per cent.

Take year 5 cash of ₹146.4 crore, grow it one more year to ₹152.3 crore, and divide by the gap between the discount rate and the growth rate: 12% − 4% = 8%, that is 0.08. The result is ₹1,903 crore. That is a value at the end of year 5, so it too must be discounted back five years, by 0.567, to ₹1,080 crore today.

Look at the weight: ₹1,080 crore out of an enterprise value of ₹1,510.8 crore is 71 per cent. Most of the answer comes from one assumption about what happens after the years you forecast. That is normal for a growing company, and it is the main reason a DCF should be read with caution.

The five forecast years and the terminal value together give the enterprise value: ₹430.8 crore + ₹1,080.0 crore = ₹1,510.8 crore. That is the worth of the whole operating business, but shareholders do not own all of it. Lenders have a claim too.

Subtract net debt, which is borrowings minus cash. Assume Ganga has borrowings of ₹300 crore and cash of ₹100 crore, so net debt is ₹200 crore. Equity value is ₹1,510.8 − ₹200 = ₹1,310.8 crore. Divide by 10 crore shares outstanding and you get ₹131.1 per share.

That ₹131.1 is what this particular set of assumptions produces. It is one point on a map, not the location of the treasure.

Now the part that matters most. Keep the same forecast, and change only the two dials that are hardest to know: the discount rate and the long-run growth rate. The table below is the same company under fifteen combinations, each of which an analyst could defend.

At a 12 per cent rate and 4 per cent growth the answer is ₹131. Move the rate to 11 per cent and it becomes ₹153. Move it to 13 per cent and it becomes ₹114. A one-point change in one assumption moves the value by about 15 per cent either way. Across the whole grid the answer runs from ₹92 to ₹216, and the top is more than twice the bottom.

Nothing about the business changed between these cells. Only two opinions did. This is why no honest analyst gives a DCF as one number. A range, with the reasoning behind each end, is the useful output.

Neither is better. They fail in different ways, and that is why using both is sound practice. Relative valuation (the previous topic) is quick and based on prices people are actually paying, but it cannot see a whole sector drifting away from reality. A DCF is anchored to the business's own cash, not to its neighbours, but it depends on assumptions that nobody can know.

When the two agree, you have some comfort. When they disagree sharply, that disagreement is the most useful finding, because it tells you which assumption to investigate. A buyer may see a DCF above the market price and ask what the market knows. A seller may see a price above the DCF and ask what the market is hoping for. The question in both cases is the same.

A DCF is most reliable where the future looks like a steadier version of the past. A mature business with stable margins, modest capital needs and a long record of cash generation gives a forecast you can defend, and the terminal value is less of a leap.

It is least reliable in four situations. A young or loss-making business has no cash to forecast from, so every number is a guess. A cyclical business swings between very high and very low cash, so the year you start from decides the answer. A bank or NBFC does not fit, because lending is its raw material and debt cannot be separated from operations; such companies are valued by other methods, covered in the banks and NBFCs topic. And a business whose cash depends on one government decision, one customer or one commodity price has a forecast that is really a bet on that one thing.

The bull case and the bear case both live inside the assumptions. A bull argues growth will last longer or margins will hold; a bear argues the opposite. The spreadsheet cannot choose between them. Only research into the business can, and even then the result is a view, not a certainty.

Because the method looks precise, it is easy to trust it too much. A model with a value to one decimal place looks like knowledge. It is not.

You do not need to build the model to test one. Ask a few questions of any DCF you read, including your own. If the answers are missing, treat the number with caution.