Understanding DCF in 5 Minutes

The 10-second version

Discounted Cash Flow (DCF) estimates what a business is worth today by forecasting the cash it will generate tomorrow and converting those future rupees (or dollars) into today’s value using a rate that reflects risk. That rate is the WACC (Weighted Average Cost of Capital). If the present value (PV) of all future free cash flows plus terminal value exceeds the current price, the asset may be undervalued.

Core idea in one line

DCF values a business by discounting free cash flows at WACC.

What exactly are we discounting?

We discount Free Cash Flow (FCF)—the cash a business can generate after spending the money required to maintain or grow its asset base. There are two common flavors:

• FCFF (to the firm): Cash available to all capital providers (debt + equity). DCF using FCFF is discounted at WACC and yields Enterprise Value.
• FCFE (to equity): Cash available to equity holders after debt flows. Discount at the cost of equity to get Equity Value.

Most professional models use FCFF + WACC because it cleanly separates operating performance (enterprise) from capital structure (how it’s financed).

What discount rate should I use?

The WACC blends the after-tax cost of debt and cost of equity weighted by their target capital structure. Intuition: safer, cheaper debt lowers WACC; riskier equity raises it. A higher WACC punishes distant cash flows more, reducing today’s value.

DCF in five steps

1. Forecast operating results for 5–10 years: revenue, margins, taxes, working capital, and capital expenditure (capex).
2. Compute FCFF each year, e.g.:
   FCFF = NOPAT + D&A − Capex − ΔWorkingCapital
   (NOPAT = EBIT × (1 − tax rate))
3. Estimate a Terminal Value (TV) after year N using either:
   • Perpetuity growth: TV = FCFFN+1 / (WACC − g), where g is long-run growth.
   • Exit multiple on a steady-state metric (e.g., EV/EBITDA).
4. Discount all FCFFs and TV back to today at WACC to get Enterprise Value (EV).
5. Bridge to Equity Value: Equity = EV − Net Debt − minority interests + non-operating assets. Divide by shares to get intrinsic price per share.

Quick worked example (toy numbers)

Suppose a company’s FCFF (₹ crore) is projected as: Year 1: 90, Year 2: 100, Year 3: 110, Year 4: 115, Year 5: 120. Assume WACC = 10% and a terminal growth rate g = 3%.

1. Discount the explicit FCFFs:
   • PV(Year 1) = 90 / 1.10 = 81.8
   • PV(Year 2) = 100 / 1.10² = 82.6
   • PV(Year 3) = 110 / 1.10³ = 82.7
   • PV(Year 4) = 115 / 1.10⁴ = 78.6
   • PV(Year 5) = 120 / 1.10⁵ = 74.5
2. Terminal Value at end of Year 5:
   FCFF₆ = 120 × 1.03 = 123.6
   TV = 123.6 / (0.10 − 0.03) = 1,765.7
   PV(TV) = 1,765.7 / 1.10⁵ = 1,095.9
3. Enterprise Value ≈ sum of PVs = 81.8 + 82.6 + 82.7 + 78.6 + 74.5 + 1,095.9 = 1,496.1
4. Subtract net debt (say 300) → Equity Value ≈ 1,196.1.
5. Divide by shares to get intrinsic value per share.

Numbers rounded for simplicity; real models include taxes, working capital cadence, and detailed capex schedules.

How to forecast FCFF fast (and sanely)

• Revenue: Anchor to a few drivers (volume × price, store count × sales/store, subscribers × ARPU). Avoid heroic growth after 3–5 years.
• Margins: Tie to operating levers and industry benchmarks; fade toward a steady-state EBIT margin.
• Taxes: Use normalized cash tax rate over the cycle, not just accounting ETR.
• Working capital: Model with days metrics (DSO, DPO, DIO) or as % of revenue.
• Capex: Link to growth and maintenance needs; check against depreciation and capacity plans.

Picking WACC without overthinking

For many quick valuations, a range is better than a single point. For a mature, stable business you might test WACC in a 8–10% band; for a riskier, high-growth firm perhaps 10–14%. Calibrate to peer costs of capital, country risk, and leverage. Remember: WACC is the biggest swing factor in DCF outcomes.

Terminal value: don’t let it dominate

In many models, terminal value (TV) drives 60–80% of total EV. Keep it realistic: long-run growth g should not exceed long-term nominal GDP growth of the core markets. If an exit multiple is used, cross-check that the implied steady-state margins and reinvestment rates make sense.

Sensitivity & sanity checks

• Sensitivity table: EV across WACC (rows) and g (cols).
• Reverse DCF: Solve for the growth/margin path implied by the current market price; is it plausible?
• Cross-methods: Compare DCF output with multiples (EV/EBITDA, P/E) and precedent transactions.
• Unit economics: Make sure per-customer or per-site economics support the aggregate story.

Common pitfalls to avoid

• Using accounting earnings instead of cash flow (forgetting working capital or capex).
• Letting TV overwhelm the valuation with an aggressive g or multiple.
• Mismatch between FCFF and discount rate (e.g., FCFE with WACC).
• Ignoring cyclicality, competitive response, or regulatory shifts.
• Not reconciling enterprise value to the balance sheet (non-operating assets, leases, pension deficits).

When to use DCF (and when not to)

DCF shines for businesses where value is clearly tied to future cash generation and you can form a view on growth, margins, and reinvestment: mature software, consumer staples, utilities, infrastructure. It struggles when cash flows are too uncertain or binary (early biotech, option-like ventures) or where economics change rapidly (hype-cycle tech) unless you explicitly model scenarios.

Five-minute checklist

• Have I linked growth to drivers and capped long-run g realistically?
• Are margins trending to a defendable steady state?
• Is capex consistent with growth and with depreciation over time?
• Do WACC and leverage reflect target (not current) structure?
• How dependent is value on the terminal assumptions?

Bottom line

DCF is a simple idea wrapped in careful assumptions. Forecast cash, pick a sensible WACC, keep the terminal value grounded, and always test sensitivities. Used with discipline, it turns a fuzzy debate about “what this company is worth” into a structured, testable view anchored in cash.