DCF Model
The Discounted Cash Flow (DCF) model is the most thorough method to value a company. It calculates what future cash flows are worth today.
DCF is powerful but sensitive to assumptions. Small changes in inputs create large changes in output. Use it as a framework, not a precise calculator.
DCF Formula
Intrinsic Value = Σ (FCF_t / (1 + r)^t) + Terminal Value
Where:
- FCF_t = Free Cash Flow in year t
- r = Discount rate
- t = Year number
- Terminal Value = Value beyond forecast period
Step-by-Step Process
Step 1: Estimate Free Cash Flow
Project FCF for 5-10 years:
| Year | FCF (₹ Cr) |
|---|---|
| 1 | 100 |
| 2 | 115 |
| 3 | 130 |
| 4 | 145 |
| 5 | 160 |
Base on:
- Historical FCF
- Expected growth
- Industry dynamics
Step 2: Choose Discount Rate
WACC (Weighted Average Cost of Capital) is standard:
| Component | Typical Range |
|---|---|
| Risk-free rate | 7-8% (India) |
| Equity risk premium | 4-6% |
| Cost of equity | 12-15% |
| Cost of debt | 8-12% |
| WACC | 10-14% |
When unsure, use a higher discount rate (12-15%). This builds in conservatism.
Step 3: Discount Cash Flows
Present Value = FCF / (1 + r)^n
| Year | FCF | Discount Factor (12%) | Present Value |
|---|---|---|---|
| 1 | 100 | 0.893 | 89 |
| 2 | 115 | 0.797 | 92 |
| 3 | 130 | 0.712 | 93 |
| 4 | 145 | 0.636 | 92 |
| 5 | 160 | 0.567 | 91 |
| Sum | **457** |
Step 4: Calculate Terminal Value
Value of all cash flows beyond forecast period.
Gordon Growth Method: Terminal Value = FCF_final × (1 + g) / (r - g)
Where:
- g = Terminal growth rate (typically 3-5%)
- r = Discount rate
Example:
- Year 5 FCF: 160
- g = 3%
- r = 12%
- Terminal Value = 160 × 1.03 / (0.12 - 0.03) = ₹1,831 Cr
Terminal value often represents 60-80% of total DCF value. Be very careful with terminal growth assumptions.
Step 5: Discount Terminal Value
Present Value of Terminal Value = 1,831 / (1.12)^5 = ₹1,039 Cr
Step 6: Sum All Values
| Component | Value (₹ Cr) |
|---|---|
| PV of 5-year FCF | 457 |
| PV of Terminal Value | 1,039 |
| Enterprise Value | **1,496** |
Step 7: Calculate Equity Value
Equity Value = Enterprise Value - Debt + Cash
| Item | Value |
|---|---|
| Enterprise Value | 1,496 |
| Less: Debt | (200) |
| Add: Cash | 50 |
| Equity Value | **1,346** |
Step 8: Calculate Per Share Value
Intrinsic Value per Share = Equity Value / Shares Outstanding
1,346 / 10 = ₹134.60 per share
Sensitivity Analysis
Test different assumptions:
| Discount Rate → | 10% | 12% | 14% |
|---|---|---|---|
| Growth 3% | 160 | 135 | 115 |
| Growth 4% | 175 | 145 | 125 |
| Growth 5% | 195 | 160 | 135 |
See how value changes with assumptions.
DCF Limitations
| Limitation | Reality |
|---|---|
| Hard to predict growth | Especially beyond 5 years |
| Discount rate subjectivity | Different analysts, different rates |
When to Use DCF
| Good For | Not Good For |
|---|---|
| Capital-light businesses | Banks, financial services |
| Long-term perspective | Short-term trading |
Never rely on DCF alone. Use it as one input alongside relative valuation and qualitative analysis.
Key Takeaways
- DCF values company based on future cash flows
- Requires projecting FCF and choosing discount rate
- Terminal value often dominates the calculation
- Sensitivity analysis tests assumption robustness
- Use conservatively as one of multiple methods
Next: Let's learn about relative valuation – comparing with similar companies.
Sources & Disclaimer
- CFA Institute - Equity Asset Valuation
- NCFM Fundamental Analysis Module
Note: Any benchmarks (e.g., "Good ROE is > 20%", or specific P/E ranges) are simplified industry heuristics for educational purposes. True evaluation depends on specific industry context, market cycles, and individual company circumstances.