Understanding DCF Valuation – A Beginner’s Guide

What is DCF Valuation?

Have you ever wondered what makes a stock “cheap” or “overpriced”? Is the share price always a fair reflection of a company’s value? – Not really.
That’s where the concept of Discounted Cash Flow (DCF) valuation comes into play. It’s a cash flow valuation technique that helps investors estimate the intrinsic value of a company, regardless of the market noise.

In simple terms, the DCF method of valuation tells you what a business is truly worth today, based on how much cash it will generate in the future.

Core Principle Behind DCF

The idea is simple yet powerful:

“A business is worth the sum of all the money it will make in the future—adjusted for today’s value.”

In other words, if you expect a company to make ₹100 crore over the next 10 years, those future earnings are not worth ₹100 crore today. They are worth less, because of inflation, risk, and opportunity cost.

So, we discount those future cash flows back to the present using a discount rate—usually based on the cost of capital or required rate of return.

The DCF Formula

Here’s the basic DCF formula:

DCF Value = FCF₁ / (1+r)¹ + FCF₂ / (1+r)² + … + FCFₙ / (1+r)ⁿ + Terminal Value / (1+r)ⁿ

Where:

• FCF = Free Cash Flow for each year
• r = Discount rate (usually WACC or required return)
• n = Number of years
• Terminal Value = Estimated value after the forecast period

Key Components of Discounted Cash Flow Valuation

1. Free Cash Flows (FCF)

Free cash flow is the money a business generates after spending on operations and capital expenses. It’s the cash available to pay debt, give dividends, or reinvest.

In DCF, we project 5–10 years of future FCF.
Indian companies like TCS, Infosys, and HUL often have predictable free cash flows, making them ideal candidates for this method.

2. Discount Rate (WACC or Required Return)

This is the “interest rate” used to bring future cash flows to present value.
Most commonly, we use:

• WACC (Weighted Average Cost of Capital) for company valuation

          (WACC = (E/V × Re) + (D/V × Rd × (1 – Tc))

Where:

           E = Market value of equity

          D = Market value of debt

          V = E + D = Total firm value (equity + debt)

          Re = Cost of equity

          Rd = Cost of debt

          Tc = Corporate tax rate

• Or a required return rate based on risk

In India, typical discount rates range between 10% and 15%, depending on sector, risk, and inflation.

3. Terminal Value

DCF doesn’t stop at Year 5 or 10. You also calculate the value of all future cash flows after the projection period.

Common methods:

• Gordon Growth Model:
  Terminal Value = Final Year FCF × (1 + g) / (r – g)
• Exit Multiple:
  Apply an industry average EV/EBITDA or P/E ratio

In India, for example, you might apply a 15x terminal multiple to a consumer goods firm or use a 5% terminal growth rate for IT companies.

4. Present Value Calculation

All projected FCFs and terminal value are discounted to their present value using the chosen discount rate. Add them together and you get the DCF Value of the business.

Realistic DCF Example

Let’s say you’re trying to estimate the DCF value of a listed Indian mid-cap IT firm.

Assumptions:

• Free Cash Flow (Year 1): ₹100 crore
• FCF Growth Rate: 12% for 5 years
• Terminal Growth Rate: 5%
• Discount Rate: 12%

FCF Projection (5 Years):

Terminal Value:

TV = 157 × (1 + 5%) / (12% – 5%) = ₹2,360 crore

Present Value of FCFs + Terminal Value:

Using the discount rate, calculate the present value of each year’s cash flow and the terminal value.

Total DCF Valuation = ₹1,642.22 crore (approx)

Compare this to the company’s current market capitalization. If it’s trading below this value, it could be undervalued.

When Should You Use DCF?

• You understand the business model
• You can reasonably forecast revenue and costs
• The company has positive and stable FCF
• You want to value a private company/startup based on projections

When DCF Might Not Work Well

• Highly cyclical industries (e.g., airlines, metals)
• Startups with negative FCF and no profitability visibility
• Companies with inconsistent reporting or poor corporate governance

Alternatives to DCF Method of Valuation

If DCF seems too assumption-heavy, here are other methods to try:

• Relative Valuation – using P/E, EV/EBITDA multiples
• Asset-based Valuation – for real estate or manufacturing firms
• Dividend Discount Model – for dividend-heavy companies like PSU banks

But remember, DCF gives the most comprehensive, long-term view of value if done properly.

Final Thoughts: DCF as a Mindset

The real power of DCF isn’t in the math—it’s in the thinking. It makes you ask: “What’s this company actually worth—not just what the market says?” That mindset helps you become a better investor—more focused on fundamentals than price movement. So, start with companies you understand. Download annual reports. Use tools like FinanceBuddy’s Free DCF Calculator. Make assumptions, test them, adjust.

The more you do it, the better your instincts will get.