Discounted Cash Flow (DCF)
We touched on this in the Valuation chapter, but now we are going to open the hood. The Discounted Cash Flow (DCF) method is the most important tool in a finance professional's toolkit. It is based on a simple, profound truth: An asset is worth exactly the sum of the cash it will provide you in the future, adjusted for the risk of waiting for that cash.
If you understand DCF, you understand how the "Smart Money" on Wall Street and Dalal Street thinks.
1. The Core Logic: The Time Machine
As we learned in the Time Value of Money chapter, ā¹100 today is worth more than ā¹100 next year. In a DCF, we take every single rupee a company is expected to earn over the next several decades and "pull it back" to today's value using a discount rate (usually the WACC).
2. The 3 Steps of a DCF
To calculate a DCF, you need to solve three distinct mathematical problems:
Step 1: Forecast Free Cash Flows (The "Projection Period")
Most analysts project cash flows for 5 to 10 years. We use Free Cash Flow (FCF) because it represents the actual cash left over after the company has paid all its bills and reinvested in its own growth.
FCF = Operating Cash Flow - Capital Expenditures
Step 2: The Terminal Value (The "Forever" Value)
A company doesn't stop existing after Year 10. Since we can't forecast every year forever, we use a formula to estimate the value of all cash flows from Year 11 until the end of time.
Terminal Value = FCFn+1\ (WACC - g}
Where g is the perpetual growth rate, usually tied to the rate of inflation or GDP).
Step 3: Discounting to Present Value
We take all the projected FCFs and the Terminal Value and divide them by our discount rate.
3. Master Example Calculation: "GreenDrive Motors"
Imagine an EV startup in Pune called GreenDrive. You want to know if it's worth investing in today.
The Assumptions:
- Year 1 FCF: ā¹100 Crores
- Growth Rate for 5 years: 10% per year
- WACC (Discount Rate): 12%
- Perpetual Growth Rate (g): 3%
Phase A: Discounting the 5-Year Cash Flows
- Year 1: $100 / (1.12)1 = 89.3
- Year 2: $110 / (1.12)2 = 87.7
- Year 3: $121 / (1.12)3 = 86.1
- Year 4: $133 / (1.12)4 = 84.5
- Year 5: $146 / (1.12)5 = 82.8
- Sum of Phase A: ā¹430.4 Crores
Phase B: Terminal Value (TV)
First, find Year 6 FCF: $146 x 1.03 = 150.4
TV =
Now, discount the TV back 5 years:
PV of TV = 1,671.1 / 1.125} = 948.2 Crores
Phase C: Total Enterprise Value
EV = Sum of Phase A + PV of TV
EV = 430.4 + 948.2 = 1,378.6 Crores
The Verdict: If the market is currently selling GreenDrive for ā¹1,000 Crores, it is a Bargain. If the market price is ā¹1,800 Crores, it is Overvalued.
4. The DCF "Sensitivity" Problem
The DCF is very sensitive.
- If you change the WACC from 12% to 11%, the value of GreenDrive might jump by ā¹200 Crores.
- If you change the Growth Rate by 1%, the value shifts significantly.
Equiscale Insight: This is why professional investors use a "Range of Values" rather than a single number. They also use a "Margin of Safety"-only buying when the price is significantly lower than their lowest DCF estimate.
Summary
- DCF is the "Intrinsic" way to value a company.
- It relies on Free Cash Flow, not accounting profit.
- The Terminal Value usually makes up 60-80% of the total value.
- It is highly sensitive to the Discount Rate (WACC).