Discounted Cash Flow

A rupee next year is worth less than a rupee today, because today's rupee can be invested. Discounted cash flow applies that idea to a whole business.

Forecast the cash for each of the next several years, work out what each of those future amounts is worth in today's money, add them up, and add a terminal value for everything after the forecast period. The total is what the business is worth.

Four steps, in order:

1. Forecast free cash flow for an explicit period, usually 5 to 10 years.
2. Pick a discount rate — the cost of equity from CAPM if discounting cash flows to equity holders, the weighted average cost of capital if discounting cash flows to the whole firm.
3. Discount each year back to the present.
4. Add a terminal value for the period beyond the forecast, then discount that too.

On a typical model the terminal value is 60% to 80% of the total answer. So a DCF is mostly a statement about what happens after the years you actually forecast — which is worth remembering before treating the output as precise.

             CF₁        CF₂              CFₙ + TVₙ
Value =  ───────── + ───────── + ... + ─────────────
          (1 + r)¹   (1 + r)²            (1 + r)ⁿ

Terminal value (Gordon growth):   TVₙ = CFₙ × (1 + g) ÷ (r − g)

where r is the discount rate and g the perpetual growth rate, which must be below r or the formula returns a negative value.

A speciality chemicals company generates Rs 200 crore of free cash flow this year, expected to grow 10% a year for five years, then 4% for ever. Discount rate 12%.

Terminal value at end of year 5:

TV = 322.1 × 1.04 ÷ (0.12 − 0.04) = 334.98 ÷ 0.08 = Rs 4,187 crore
PV of TV = 4,187 × 0.567 = Rs 2,374 crore

Enterprise value = 947.6 + 2,374 = Rs 3,322 crore, of which the terminal value is 71%.

Change perpetual growth from 4% to 5% and the terminal value jumps to Rs 4,830 crore — the whole valuation rises about 19% on a one-point change in a number nobody can know.

Chapter 10 (Valuation Principles) is where this is taught and it is one of the most heavily examined chapters in the paper. Expect present-value arithmetic, the Gordon growth formula, and conceptual questions on why the terminal value dominates.

• Match the cash flow to the discount rate. FCFE is discounted at the cost of equity and gives equity value directly. FCFF is discounted at WACC and gives enterprise value, from which debt must still be subtracted. Mixing them is the most common error in the chapter.
• Perpetual growth must be below the discount rate. It should also not exceed long-run nominal GDP growth — no company outgrows its economy for ever.
• The terminal value is discounted by the year-n factor, not the year n+1 factor.
• A DCF is a sensitivity exercise, not an answer. Always present a range.