DCF valuation (Discounted Cash Flow valuation) is the most widely used method for estimating the intrinsic value of a business or a stock. Instead of asking what the market is paying today, a DCF asks a different question: what are all the cash flows this business is expected to generate in the future worth in today’s rupees? This guide explains the DCF formula, the step-by-step DCF calculation, free cash flow to firm (FCFF) versus free cash flow to equity (FCFE), WACC, terminal value, a fully worked numerical example, sensitivity analysis, reverse DCF and where the method works well or poorly. It is written for retail investors, students and analysts evaluating Indian listed companies.
What Is DCF Valuation?
DCF valuation is built on the time value of money: a rupee received five years from now is worth less than a rupee received today, because today’s rupee can be invested to earn a return and because future cash carries uncertainty. A DCF therefore projects the cash a business is expected to produce, then “discounts” each future amount back to the present using a rate that reflects the risk of those cash flows.
The sum of all discounted cash flows is the intrinsic value of the business. When this value is divided by the number of shares (after adjusting for debt and cash), the result is an estimated intrinsic value per share, which may be compared with the current market price (CMP) to judge whether a stock appears undervalued, fairly valued or overvalued.
- Question answered: what is the business worth?
- Based on: future cash, not price
- Output: intrinsic value per share
- Compared with: CMP and margin of safety
The DCF Formula and Its Logic
Core DCF Formula
Enterprise Value = Σ [ FCFt ÷ (1 + r)t ] + [ Terminal Value ÷ (1 + r)N ]
Terminal Value (Gordon Growth) = FCFN × (1 + g) ÷ (r − g)
Equity Value = Enterprise Value − Net Debt (debt − cash) − Minorities + Non-operating assets
Value per Share = Equity Value ÷ Number of Shares
Here, FCFt is the free cash flow in year t, r is the discount rate (WACC for FCFF, cost of equity for FCFE), N is the last year of the explicit forecast, and g is the perpetual growth rate after that year. The logic has only three moving parts: how much cash is generated, how fast it grows, and how heavily the future is discounted. Almost every debate about a DCF is a debate about one of these three.
DCF Calculation: Step-by-Step Method
- Understand the business. Identify revenue drivers, margins, capital intensity and cyclicality. A DCF on a business that is not understood is only arithmetic.
- Project revenue. Use volume, price and segment drivers, anchored to historical CAGR and industry growth, typically for 5 to 10 years.
- Project operating profit (EBIT/EBITDA). Apply margin assumptions that reflect operating leverage, input costs and competition.
- Estimate free cash flow. Convert profit to cash after tax, depreciation, capital expenditure and working capital (see Section 04).
- Determine the discount rate. Compute WACC (or cost of equity) from market inputs (see Section 05).
- Compute terminal value. Capture value beyond the forecast period using perpetual growth or an exit multiple (see Section 06).
- Discount and add. Discount each year’s FCF and the terminal value to today and sum them to get enterprise value.
- Bridge to equity value. Subtract net debt and minorities, add non-operating assets, and divide by diluted shares.
- Stress-test. Run sensitivity and scenario analysis, then compare with relative valuation and market price.
Free Cash Flow: FCFF vs FCFE Calculation
Free cash flow is the cash left over after a business has paid for the investments needed to sustain and grow itself. Two versions are used in practice.
| Measure | Formula | Discount with | Gives |
|---|---|---|---|
| FCFF (Free Cash Flow to Firm) | EBIT × (1 − tax rate) + Depreciation − Capex − Increase in Working Capital | WACC | Enterprise value |
| FCFE (Free Cash Flow to Equity) | FCFF − Interest × (1 − tax rate) + Net Borrowing | Cost of equity | Equity value directly |
| Quick alternative | Cash Flow from Operations − Capex | WACC or Ke | Approximate FCF |
FCFF is capital-structure neutral and is the usual choice for non-financial companies. FCFE is useful when leverage is stable and the equity holder’s cash is the focus. For banks and NBFCs, where debt is raw material rather than financing, equity-based approaches such as FCFE, dividend discount or residual income are generally more suitable than FCFF.
WACC: Choosing the Discount Rate
The Weighted Average Cost of Capital blends the cost of equity and the after-tax cost of debt in proportion to their weights in the capital structure.
WACC Formula
WACC = E/(D+E) × Ke + D/(D+E) × Kd × (1 − Tax)
Cost of Equity (CAPM): Ke = Risk-free rate + Beta × Equity Risk Premium
| Input | Assumption | Calculation |
|---|---|---|
| Risk-free rate (10-yr G-Sec proxy) | 7.0% | Government bond yield |
| Beta | 1.2 | Sensitivity to the market |
| Equity risk premium | 6.0% | Expected market return over risk-free |
| Cost of equity (Ke) | 14.2% | 7.0% + 1.2 × 6.0% |
| Pre-tax cost of debt | 9.0% | Average borrowing rate |
| After-tax cost of debt (Kd) | 6.75% | 9.0% × (1 − 25%) |
| Weights (Equity / Debt) | 70% / 30% | Target capital structure |
| WACC | ≈ 12.0% | 0.70 × 14.2% + 0.30 × 6.75% = 11.97% |
In practice, many Indian analysts use a flat 11% to 13% WACC for mid and large caps, higher for small caps and cyclical businesses. Because the discount rate has an outsized effect on value, small changes should always be tested.
Terminal Value: Gordon Growth vs Exit Multiple
No forecast can run forever, so the value of cash flows beyond the explicit period is captured in a terminal value. It frequently contributes 60% to 80% of total DCF value, which is why it deserves the most scrutiny.
| Method | Formula | Strength | Watch-out |
|---|---|---|---|
| Gordon (perpetual) growth | FCFN × (1 + g) ÷ (r − g) | Internally consistent, tied to fundamentals | Very sensitive when r − g is small |
| Exit multiple | FCFN or EBITDAN × market multiple | Anchors to market reality | Imports market over- or under-valuation into the DCF |
As a rule of thumb, the terminal growth rate g should not exceed the long-run nominal growth of the economy; for India, 4% to 6% is the range commonly regarded as defensible, and the rate should always remain well below the discount rate.
DCF Valuation Example: Worked Calculation
Consider a hypothetical company, Example Industries Ltd. Its first-year free cash flow to firm is ₹100 crore, expected to grow 14%, 13%, 12% and 10% in the following four years. WACC is 12%, terminal growth is 5%, net debt is ₹150 crore and there are 10 crore shares. The figures are illustrative and not a real company.
Step 1: Forecast and discount the free cash flows
| Year | FCFF (₹ cr) | Discount factor @12% | Present value (₹ cr) |
|---|---|---|---|
| 1 | 100.0 | 0.8929 | 89.3 |
| 2 | 114.0 | 0.7972 | 90.9 |
| 3 | 128.8 | 0.7118 | 91.7 |
| 4 | 144.3 | 0.6355 | 91.7 |
| 5 | 158.7 | 0.5674 | 90.1 |
| Sum of PV (Years 1 to 5) | 453.6 |
Step 2: Terminal value, enterprise value and per-share value
| Item | Calculation | ₹ crore |
|---|---|---|
| Terminal value at Year 5 | 158.7 × 1.05 ÷ (12% − 5%) | 2,380.6 |
| PV of terminal value | 2,380.6 × 0.5674 | 1,350.8 |
| PV of Years 1 to 5 | From Step 1 | 453.6 |
| Enterprise value | 453.6 + 1,350.8 | 1,804.4 |
| Less: net debt | Debt − cash | (150.0) |
| Equity value | 1,654.4 | |
| Intrinsic value per share | 1,654.4 ÷ 10 crore shares | ₹165.4 |
Notice that the terminal value contributes about 75% of enterprise value. If the stock were trading at ₹120, the result would suggest a margin of safety of roughly 27%; if it traded at ₹200, the market would be pricing in more than this model assumes. An exit-multiple cross-check at 12× Year-5 FCFF gives a lower value of about ₹138 per share, which illustrates why more than one terminal method is generally compared.
DCF Sensitivity Analysis
Because a DCF output is only as reliable as its inputs, analysts present a grid showing how value per share changes with WACC and terminal growth. For the example above:
| WACC \ Terminal growth | 4.0% | 5.0% | 6.0% |
|---|---|---|---|
| 11% | ₹172 | ₹196 | ₹231 |
| 12% | ₹147 | ₹165 | ₹189 |
| 13% | ₹129 | ₹142 | ₹160 |
A change of one percentage point in WACC moves value by roughly 15% to 20%. This is the reason that a single-point DCF target should be read as the centre of a range, not as a precise price. Many analysts therefore pair the DCF with bear, base and bull scenarios.
DCF Model Variants and When Each Fits
| Model | Cash flow discounted | Rate | Suited to |
|---|---|---|---|
| FCFF DCF | Free cash flow to firm | WACC | Manufacturers, consumer, pharma, IT, infrastructure |
| FCFE DCF | Free cash flow to equity | Cost of equity | Companies with stable leverage |
| Dividend Discount Model | Dividends | Cost of equity | Mature, high-payout companies |
| Residual Income / Excess Return | Profit above cost of equity on book value | Cost of equity | Banks, NBFCs, insurers |
| Sum-of-the-Parts DCF | Each segment valued separately | Segment WACC | Conglomerates, holding structures |
Usability: Where DCF Works and Where It Struggles
Where DCF is useful
- Businesses with stable, predictable cash flows (FMCG, utilities, mature IT services, pharma)
- Forces explicit, testable assumptions about growth, margins and risk
- Independent of short-term market sentiment
- Highlights what is already priced in through reverse DCF
- Works for comparing companies across sectors on a cash basis
Where DCF struggles
- Start-ups and loss-making firms with little cash-flow history
- Highly cyclical businesses (commodities, shipping) with volatile cash
- Banks and NBFCs under plain FCFF, since debt is operating input
- Terminal value dominates the result, magnifying assumption errors
- False precision: small input changes move the answer materially
The practical lesson is that DCF is best treated as one lens within a wider framework that also includes relative valuation, asset value and earnings power value, so that no single assumption decides the conclusion.
Reverse DCF: What Is the Market Pricing In?
A reverse DCF starts from the current market price and solves for the assumption needed to justify it. In the example above, suppose the stock trades at ₹200 per share. Holding the forecast and a 12% WACC unchanged, the implied equity value is ₹2,000 crore and enterprise value ₹2,150 crore. Solving for terminal growth gives an implied g of about 6.35%, which is above the 4% to 6% range regarded as defensible.
This type of result would be read as the market embedding optimistic expectations, either faster growth, higher margins or a lower discount rate than the base case. Reverse DCF is particularly helpful for glamour stocks, where the key question is not the value but the expectation embedded in the price.
Common DCF Mistakes to Avoid
- Terminal growth too high. Using 7% to 8% in perpetuity implies the company outgrows the economy forever.
- Ignoring reinvestment. Growth requires capex and working capital; high growth with low reinvestment is inconsistent.
- Using accounting profit instead of cash. Net profit can differ sharply from free cash flow.
- Mismatched cash flow and rate. Discounting FCFF at cost of equity, or FCFE at WACC, produces wrong values.
- Forgetting the equity bridge. Debt, cash, minorities, leases and contingent liabilities must be adjusted.
- Using one-year peaks or troughs as the base. Normalise exceptional gains, losses and cyclical extremes.
- Over-trusting a single number. Always present a range with sensitivity and scenarios.
DCF for Indian Stocks: Practical Settings
| Input | Typical range | Comment |
|---|---|---|
| Forecast period | 5 to 10 years | Longer for high-growth businesses that need time to mature |
| WACC / cost of equity | 11% to 14% | Higher for small caps and cyclicals |
| Terminal growth | 4% to 6% | Anchored to long-run nominal GDP growth |
| Tax rate | 25% to 26% | Use the effective rate where it differs |
| Margin of safety | 20% to 30% | Buffer for forecasting error |
| Financials | Residual income / FCFE | Avoid FCFF for banks and NBFCs |
Indian analysts also commonly adjust for promoter pledging, related-party transactions, regulatory risk and capital-allocation track record, either through a higher discount rate or a haircut to fair value. Recent news and sentiment may be overlaid on the DCF output as a discount or premium rather than ignored.
Key Takeaways
Summary
DCF valuation converts future free cash flows into a present value using a risk-adjusted discount rate, with terminal value capturing the long run. Its strength is discipline: every assumption about growth, margins, reinvestment and risk is made explicit. Its weakness is sensitivity: modest changes in WACC or terminal growth can move value materially, and terminal value often exceeds 70% of the total. A DCF should therefore be viewed as a range supported by sensitivity tables, scenarios, reverse DCF and cross-checks against relative valuation, rather than a single price target. Readers may consider using it most heavily for stable cash generators, relying on alternative models for banks, cyclicals and early-stage businesses.
DCF Valuation: Frequently Asked Questions
What is DCF valuation in simple words?
DCF valuation estimates what a business is worth today by adding up all the cash it is expected to generate in future, each discounted back to the present for time and risk.
What is the DCF formula?
Value = sum of FCFt ÷ (1 + r)t for each forecast year, plus terminal value ÷ (1 + r)N. Terminal value under Gordon Growth equals FCFN × (1 + g) ÷ (r − g).
What is the difference between FCFF and FCFE?
FCFF is cash available to all capital providers and is discounted at WACC to give enterprise value. FCFE is cash available to shareholders after debt servicing and is discounted at the cost of equity to give equity value directly.
What discount rate and terminal growth are generally used for Indian stocks?
A discount rate of about 11% to 14% and terminal growth of about 4% to 6% are commonly used, with higher discount rates for riskier small caps and cyclicals.
Is DCF reliable?
DCF is reliable only to the extent that its assumptions are. It is more dependable for businesses with stable cash flows and less so for start-ups, cyclicals and financial companies, which is why sensitivity analysis and cross-checks with other methods are advisable.