DCF estimates intrinsic value by discounting projected future free cash flows at WACC Three components: Free Cash Flow, Discount Rate (WACC), and Terminal Value Terminal value typically represents 60–80% of enterprise value — making growth rate assumptions critical
What is Discounted Cash Flow (DCF) Analysis?
Discounted Cash Flow (DCF) analysis is an intrinsic valuation method that estimates the fair value of a company by projecting its future free cash flows and discounting them back to the present using a rate that reflects investment risk. If the intrinsic value produced by DCF exceeds the current market price, the stock is undervalued. If it is below the market price, the stock may be overvalued. For NISM Series XV Research Analyst candidates, DCF is the most exam-critical valuation technique to master.
Why DCF is the Foundation of Equity Research
Research analysts distinguish between two broad approaches to valuation: intrinsic valuation and relative valuation. Relative valuation compares a stock's P/E or EV/EBITDA against peers. Intrinsic valuation asks what this business is worth on its own merits, independent of what the market currently prices similar companies at. DCF is the primary intrinsic valuation tool.
The central insight is simple: money today is worth more than money in the future, because money today can be invested and earn returns. If a company promises to pay you ₹1,00,000 three years from now, you need to discount that future payment back to its present value to know what you'd rationally pay for it today. DCF formalises this logic across an entire business's projected cash flow stream.
The Three Components of a DCF Model
1. Free Cash Flow (FCF)
Free Cash Flow is the cash a business generates after paying for its operating expenses and capital expenditures. The formula is: FCF = Operating Cash Flow − Capital Expenditure. Analysts typically project FCF for 5–10 years based on revenue growth assumptions, margin trends, and capex intensity.
2. Discount Rate (WACC)
The Weighted Average Cost of Capital (WACC) is the rate used to discount future cash flows. Formula: WACC = (E/V × Re) + (D/V × Rd × (1 − T)). A higher WACC (riskier company) produces a lower present value for the same cash flows.
3. Terminal Value
Terminal Value (TV) captures all cash flows beyond the explicit projection period. Gordon Growth Model: TV = FCF(n+1) / (WACC − g), where g is the long-term sustainable growth rate (typically 3–5%). Terminal value accounts for 60–80% of total enterprise value in most DCF models.
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Step-by-Step DCF Example
Consider AlphaFinance Ltd: Current FCF ₹100 Cr, FCF growth 15%/year for 5 years, WACC 12%, terminal growth 4%, net debt ₹200 Cr, 10 crore shares outstanding.
Step 1 — Project FCF: Yr1 ₹115Cr, Yr2 ₹132Cr, Yr3 ₹152Cr, Yr4 ₹175Cr, Yr5 ₹201Cr.
Step 2 — Discount to PV at 12%: Sum of discounted FCFs = ~₹510 Cr.
Step 3 — Terminal Value: TV = (201×1.04)/(0.12−0.04) = ₹2,613 Cr. Discounted PV = ₹1,482 Cr.
Step 4 — Enterprise Value: EV = 510 + 1,482 = ₹1,992 Cr.
Step 5 — Equity per share: (1,992 − 200) / 10 = ₹179.2 per share. Stock at ₹130 = 38% undervalued on DCF basis.
Limitations of DCF Analysis
DCF is powerful but highly sensitive to assumptions. A 1% change in WACC or terminal growth rate shifts valuation by 20–30%. Key limitations: (1) Garbage-in, garbage-out — optimistic projections inflate valuations. (2) Terminal value dominance — TV is 60–80% of EV, so the long-term growth assumption matters most. (3) Loss-making companies — DCF fails when FCF is negative.
DCF vs Relative Valuation: When to Use Which
DCF is most reliable for companies with stable, predictable cash flows — FMCG, utilities, mature IT. For high-growth startups or cyclical businesses, relative valuation (P/E, EV/EBITDA) is more practical. Best practice: triangulate — DCF for intrinsic value, relative valuation for market context.
NISM XV Exam Practice Questions
Q1. If WACC increases from 10% to 13%, what happens to DCF value?
Answer: DCF value decreases. A higher discount rate reduces the PV of all future cash flows.
Q2. What is the Gordon Growth Model used for in DCF?
Answer: To calculate Terminal Value. TV = FCF(n+1) / (WACC − g). It assumes the business grows at a constant rate g forever beyond the forecast period.
Q3. Why does terminal value represent 60–80% of enterprise value?
Answer: The explicit projection period (5–10 years) captures only a fraction of a company's expected life. The terminal value captures all subsequent cash flows — the bulk of a long-lived business's total worth.
Related: P/E Ratio Guide → | Reading a P&L Statement → | NISM XV Complete Guide →