Discounted Cash Flow (DCF) Analysis

As a mango seller, what if you could estimate how much your orchard is worth today? If you have an idea of how many mangoes the trees would produce each year and the price you could sell them for, could you calculate its value? You would also have to consider that money earned in the future is less valuable than money in hand today. This simple logic is the foundation of the Discounted Cash Flow (DCF) Analysis \u2014 one of the most respected methods of valuing a business.

What is DCF Analysis?

DCF Analysis estimates the present value of a company based on its expected future cash flows. In simple terms, it helps answer the question: “If this company generates ₹X every year in the future, what is that stream of income worth today?” This method relies on the principle of the time value of money, where future cash is discounted to reflect its lower value compared to today's cash.

Key Steps in DCF Analysis

1. Forecasting Free Cash Flows (FCF): Estimate how much free cash the business is likely to generate over the next few years. Free cash flow is the money left after the company has covered its operating expenses and capital expenditures.

2. Forecasting Free Cash Flows (FCF): Estimate how much free cash the business is likely to generate over the next few years. Free cash flow is the money left after the company has covered its operating expenses and capital expenditures.
   

3. Selecting a Discount Rate: Choose an appropriate discount rate, usually based on the company’s cost of capital or expected investment return. This rate reflects the riskiness of the cash flows.
   

4. Calculating Terminal Value: Since businesses continue beyond just a few years, a terminal value is calculated to account for cash flows beyond the forecasted period.
   

5. Discounting Cash Flows and Terminal Value: Apply the discount rate to the estimated cash flows and terminal value to arrive at their present values.
   

6. Adding it All Up: Summing all the discounted cash flows gives the total present value, which represents the estimated worth of the business today.
   

Formula for Present Value (PV):
PV = FCF₁ / (1 + r)¹ + FCF₂ / (1 + r)² + ... + FCFₙ / (1 + r)ⁿ + TV / (1 + r)ⁿ

Where:

• FCF = Free Cash Flow
  

• r = Discount rate
  

• n = Year number
  

• TV = Terminal Value
  

Example:

Suppose HDFC Bank is expected to generate ₹10,000 crore in free cash flow next year, growing at 8% annually. If investors require a 10% return, the DCF method would discount all future cash flows back to today, adjusting for growth and risk. Adding up these discounted cash flows would provide an estimate of HDFC Bank’s intrinsic value.

Why is DCF Powerful?

• Focuses on fundamentals: It doesn't depend on how the market values other companies.
  

• Customisable: Assumptions about growth, risk, and cash generation can be tailored to each business.
  

• Long-term oriented: Ideal for investors seeking to understand the intrinsic value rather than market hype.
  

Limitations of DCF:

• Highly sensitive to assumptions (especially growth rates and discount rates).
  

• Difficult for companies with unpredictable cash flows (like early-stage startups).
  

Discounted Cash Flow analysis is like forecasting the future harvest of a mango orchard and calculating what it’s worth today. It demands thoughtful assumptions and careful calculations but offers deep insights into a company's real value. In the next chapter, we will take a closer look at how to calculate Free Cash Flow (FCF) — the key ingredient for building a robust DCF model.