Discounted Cash Flow (DCF) Overview

If relative valuation is about what the market is paying, Discounted Cash Flow (DCF) is about what a company is actually worth based on its ability to generate cold, hard cash. It is widely considered the most theoretically sound method of valuation because it looks past market hype and focuses on the fundamental "fuel" of any business: Free Cash Flow.

1. The Core Philosophy

The DCF is built on the Time Value of Money (TVM) principle: ₹1 today is worth more than ₹1 tomorrow because ₹1 today can be invested to earn interest.

In a DCF, you estimate all the money a company will ever make in the future and then "discount" those amounts back to what they are worth in today's terms.

2. The 5-Step DCF Process

Building a DCF is a linear process that combines historical data with future assumptions.

1. Forecast Free Cash Flows (FCF): Typically, analysts project 5 to 10 years of cash flows based on revenue growth and profit margin assumptions.
2. Calculate the Discount Rate (WACC): You determine the Weighted Average Cost of Capital, which represents the risk and the "required return" investors expect for their money.
3. Determine the Terminal Value (TV): Since a company lives beyond 10 years, you calculate a single lump sum to represent all cash flows from Year 11 into infinity.
4. Discount Everything to the Present: Apply the WACC to every year's FCF and the Terminal Value to find their Net Present Value (NPV).
5. Calculate Intrinsic Value: Sum these present values to arrive at the total Enterprise Value. Subtract debt and add cash to find the Equity Value (the stock's true price).

3. The DCF Formula

For those who like the math, the simplified version looks like this:

DCF =

• CF: Cash flow for a given year.
• r: The discount rate (WACC).
• n: The year number.
• TV: Terminal Value.

4. Pros and Cons of DCF