Learn discounted cash flow (DCF) modeling — Stock-Market notes

What Is DCF Modeling?

Why does this work? Because a stock is ownership in a business, and a business is valuable only if it generates cash you can eventually extract (as dividends, buybacks, or sale proceeds). Everything else—earnings, revenue, hype—matters only insofar as it produces cash.

The DCF Formula: Built From First Principles

Step 1: Why Do We Discount?

The time value of money:₹1 today ≠ ₹1 tomorrow.

If you have ₹1 today and can invest it at rate $r$ , in one year you'll have: $\text{Future Value} = 1 \times (1 + r)$

Flip it: if someone promises you ₹1 next year, what's it worth today? $\text{Present Value} = \frac{1}{(1 + r)}$

In $n$ years: $PV = \frac{\text{Cash Flow}_n}{(1 + r)^n}$

Why this step? We're normalizing all cash flows to a single point in time (today) so we can compare and add them. You can't add ₹100 today + ₹100 in 2030—they're different "currencies" in terms of time.

Step 2: The Full DCF Equation

Suppose a company generates free cash flow $FCF_t$ in year $t$ . The Enterprise Value (value of the entire business) is:

Why terminal value? We can't forecast cash flows forever. After year $n$ , we assume the company grows at a stable rate $g$ forever: $TV = \frac{FCF_{n+1}}{WACC - g} = \frac{FCF_n \times (1 + g)}{WACC - g}$

This is the Gordon Growth Model—a perpetuity formula. If something pays $C$ next year and grows at $g\%$ per year, its value today is $\frac{C}{r - g}$ (derived from suming an infinite geometric series).

Why this formula? $\sum_{t=1}^{\infty} \frac{C(1+g)^{t-1}}{(1+r)^t} = \frac{C}{r-g} \quad \text{(when } r > g \text{)}$

Step 3: From Enterprise Value to Equity Value

Enterprise Value includes the valueowed to all capital providers (debt + equity). To get the value of just the equity (stock):

Why?

Cash already belongs to equity holders (it's on the balance sheet).
Debt must be paid off first (debtholders have priority).
Preferred stock and minority interests are other claims that rank above common equity.

Then: $\text{Intrinsic Value per Share} = \frac{\text{Equity Value}}{\text{Shares Outstanding}}$

Figure — Learn discounted cash flow (DCF) modeling

How to Build a DCF Model: Step-by-Step

Step 1: Project Free Cash Flows

Free Cash Flow = cash the business generates after paying for operations and capital expenditures.

$FCF = EBIT \times (1 - \text{Tax Rate}) + \text{D\&A} - \text{Capex} - \Delta NWC$

Or equivalently: $FCF = \text{Operating Cash Flow} - \text{Capex}$

Why this matters? FCF is what's left for investors (both debt and equity). You project this for 5-10 years based on:

Historical growth rates
Industry trends
Management guidance
Your own assumptions (conservative is better)

Step 2: Calculate WACC

$WACC$ is the blended cost of capital from debt and equity:

Why the $(1-T)$ on debt? Interest is tax-deductible, so debt is "cheaper" after tax savings.

Step 3: Discount Each FCF

For each year $t$ : $PV_t = \frac{FCF_t}{(1 + WACC)^t}$

Step 4: Calculate Terminal Value

Choose a perpetual growth rate $g$ (usually 2-3%, roughly GDP growth—companies can't grow faster than the economy forever): $TV = \frac{FCF_n (1 + g)}{WACC - g}$

Then discount it: $PV(\text{TV}) = \frac{TV}{(1 + WACC)^n}$

Step 5: Sum It All Up

$EV = \sum_{t=1}^{n} PV_t + PV(\text{TV})$

Then adjust for cash and debt to get Equity Value, divide by shares outstanding.

Worked Example: DCF for "TechCo"

Given:

Year 1-5 projected FCF: ₹100 Cr, ₹110 Cr, ₹121 Cr, ₹133 Cr, ₹146 Cr
WACC = 10%
Terminal growth rate $g = 3\%$
Cash = ₹50 Cr, Debt = ₹200 Cr
Shares outstanding = 10 Cr

Step 1: Discount each FCF

Year	FCF (₹ Cr)	Discount Factor $(1.10)^t$	PV (₹ Cr)
1	100	.10	90.91
2	110	1.21	90.91
3	121	1.331	90.91
4	133	1.464	90.85
5	146	1.611	90.63

Why these calculations? Each PV = $\frac{FCF_t}{(1.10)^t}$ . For example, year 1: $\frac{100}{1.10} = 90.91$ .

Sum of PV of explicit FCFs = ₹454.21 Cr

Step 2: Terminal Value

$TV = \frac{146 \times 1.03}{0.10 - 0.03} = \frac{150.38}{0.07} = 2,148.29 \text{ Cr}$

Why? Year 6FCF = $146 \times 1.03 = 150.38$ . Perpetuity formula.

$PV(\text{TV}) = \frac{2,148.29}{(1.10)^5} = \frac{2,148.29}{1.611} = 1,333.54 \text{ Cr}$

Step 3: Enterprise Value

$EV = 454.21 + 1,333.54 = 1,787.75 \text{ Cr}$

Step 4: Equity Value

$\text{Equity Value} = 1,787.75 + 50 - 200 = 1,637.75 \text{ Cr}$

Why add cash and subtract debt? Cash is already ours; debt must be paid off.

Step 5: Intrinsic Value per Share

$\text{Intrinsic Value} = \frac{1,637.75}{10} = ₹163.78 \text{ per share}$

Interpretation: If TechCo trades at ₹120, it's undervalued (buy). If at ₹200, overvalued (sell).

Common Mistakes & How to Fix Them

The Sensitivity of DCF: Why Small Changes = Big Swings

DCF is highly sensitive to:

WACC: A1% change can swing valuation by 15-20%.
Terminal growth rate: Difference between 2% and 4% can double the terminal value.
FCF projections: Garbage in, garbage out.

Example: For TechCo, if we used WACC = 12% instead of 10%:

$PV(\text{TV}) = \frac{2,148.29}{(1.12)^5} = 1,219.13 \text{ Cr}$

New intrinsic value ≈ ₹147 per share (down from ₹163.78). That's 10% lower valuation from a 2% WACC change.

Lesson: Always run sensitivity analysis. Create a table showing intrinsic value across different WACC and terminal growth assumptions.

When to Use DCF (and When Not To)

Use DCF when:

The company has predictable, positive cash flows (mature tech, consumer staples, industrials)
You can reasonably forecast 5-10 years
Capital structure is stable

Don't use DCF for:

Startups (no cash flows, high uncertainty)
Financial companies (banks, insurers—use P/B or dividend discount instead)
Cyclical companies at peak/trough (distorts projections)
High-growth with unclear path to profitability (too speculative)

For those, use relative valuation (P/E, P/S multiples) or stage-adjusted models.

Connections

Weighted Average Cost of Capital (WACC): The discount rate that makes DCF work
Free Cash Flow (FCF): The "fuel" of the DCF engine
Terminal Value Calculation: Handling the perpetuity
Gordon Growth Model: The math behind terminal value
Comparable Company Analysis: Alternative valuation method (relative vs. intrinsic)
Time Value of Money: The foundational principle
Beta and Cost of Equity: How to estimate $r_e$ for WACC
Sensitivity Analysis: Testing how assumptions impact valuation

Recall Explain to a 12-year-old

Imagine you have a lemonade stand. I want to buy it from you. How much should I pay?

Well, I should pay based on how much money (cash, not just "profit" on paper) the stand will make for me in the future. Let's say it makes ₹100 next year,₹110 the year after, and so on.

But here's the thing: ₹100 next year isn't as good as ₹100 today, because if I had₹100 today, I could put it in the bank and it would become ₹110 next year (at 10% interest). So that future ₹100 is only worth about ₹91 to me today.

DCF does this for every year: it asks "what's all the future lemonade stand cash worth in today's money?" Add it all up, and that's the fair price. If you're asking for more, I'm overpaying. If less, it's a good deal!

#flashcards/stock-market

What are the three main steps in DCF modeling? :: 1. Project future free cash flows, 2. Discount them to present value using WACC, 3. Sum them and adjust for cash/debt to get equity value.

What is the DCF formula for enterprise value?

EV = \sum_{t=1}^{n} \frac{FCF_t}{(1+WACC)^t} + \frac{TV}{(1+WACC)^n}

where TV is terminal value.

Why do we discount future cash flows?

Because of the time value of money—₹1 today is worth more than ₹1 tomorrow since you can invest it and earn returns.

What is the formula for terminal value in DCF?

TV = \frac{FCF_n (1+g)}{WACC - g}

where

g

is the perpetual growth rate.

How do you convert enterprise value to equity value?

Equity Value = EV + Cash - Debt - Preferred Stock - Minority Interest.

What is Free Cash Flow (FCF)?

Cash available to all investors after operating expenses and capital expenditures:

FCF = Operating\ Cash\ Flow - Capex

What is WACC?

Weighted Average Cost of Capital—the blended required return for debt and equity investors:

WACC = \frac{E}{E+D} r_e + \frac{D}{E+D} r_d(1-T)

Why is the terminal growth rate usually 2-3%?

Companies can't grow faster than the economy indefinitely; 2-3% approximates long-term GDP growth in mature economies.

What's wrong with using a 10% terminal growth rate?

It implies the company will eventually become larger than the entire economy, which is impossible.

Why do we use FCF instead of net income in DCF?

Net income includes non-cash items and ignores capex; FCF is actual cash available to investors.

If WACC increases, what happens to intrinsic value?

It decreases (higher discount rate → lower present values).

What is the present value of ₹100 received in 3 years at 10% discount rate?

\frac{100}{(1.10)^3} = \frac{100}{1.331} = ₹75.13

Why is debt subtracted when calculating equity value?

Because debtholders have priority—equity holders own what's left after debt is paid off.

Why is cash added when calculating equity value?

Because cash on the balance sheet already belongs to equity holders.

What does it mean if a stock's intrinsic value (DCF) is higher than its market price?

The stock is undervalued—a potential buy opportunity.

Concept Map

Hinglish (regional understanding)

Intuition Hinglish mein samjho

DCF matlab "Discounted Cash Flow"—yeh ek valuation method hai jo bata hai ki kisi company ka intrinsic value (asli worth) kya hai. Idea simple hai: ap ek stock khareedte ho to asal mein ap us company ke future cash flows khareedte ho. Lekin ₹100 aj aur ₹100 panch saal bad—dono barabar nahi hote. Kyunki aaj ka₹100 ap invest kar sakte ho aur 10% returns pe5 saal mein ₹161 ban jayega. To 5 saal bad ka ₹100 aj sirf ₹62 ke barabar hai. Isi logic ko DCF use karta hai har saal ke cash flow pe.

Process yeh hai: Pehle aap company ke agle 5-10 saal ke free cash flows (FCF) project karte ho—wo paisa jo business operations aur capital expenses ke baad bacha. Phir har saal ke FCF ko ap discount karte ho ek rate se (WACC—weighted average cost of capital) taki sab cash flows ko "aj ke paiso mein" convert kar sako. Sab ko jod do—yeh ban gaya enterprise value (pori company ka value). Phir cash add karo, debt minus karo, aur shares se divide karo—mil gaya intrinsic value per share. Agar market price isse kam hai, stock undervalued hai (khareedne ka mauka); zyada hai to overvalued.

DCF powerful hai kyunki yeh guesswork nahi—yeh maths aur logic pe based hai. Lekin careful rehna padta hai assumptions ke sath: WACC mein 1-2% ka fark bhi valuation ko 15-20% badal sakta hai. Aur terminal growth rate (perpetuity assumption) galat rakha to model explosion ho jayega. Isliye hamesha sensitivity analysis run karo—different WACC aur growth rates pe value check karo. DCF best kaam karta hai stable, predictable cash flow wali companies ke liye (mature tech, FMCG). Startups ya cyclical businesses ke liye yeh risky hai—wahan relative valuation (P/E multiples) better hota hai.

Test yourself — Valuation Methods

Connections