Discounted Cash Flow
Also written DCF · Discounted Cash Flow (DCF) · DCF valuation · DCF model
A valuation method that estimates the cash a business will generate in future years and converts each year back to what it is worth today.
In plain language
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.
How it works
Four steps, in order:
- Forecast free cash flow for an explicit period, usually 5 to 10 years.
- 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.
- Discount each year back to the present.
- 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.
The formula
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 worked example
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%.
| Year | Free cash flow (Rs cr) | Discount factor at 12% | Present value (Rs cr) |
|---|---|---|---|
| 1 | 220.0 | 0.893 | 196.4 |
| 2 | 242.0 | 0.797 | 192.9 |
| 3 | 266.2 | 0.712 | 189.5 |
| 4 | 292.8 | 0.636 | 186.2 |
| 5 | 322.1 | 0.567 | 182.6 |
| Sum of years 1–5 | 947.6 |
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.
Why NISM asks about it
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.
Common exam traps
- 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.
Check yourself
1.A bond pays 9% interest a year and will be redeemed at its face value of ₹1,00,000 at the end of year 10. Investors had expected a 9% return for this maturity and credit quality, but that expectation now rises to 10%. What happens to the bond's value?
- a)It stays at ₹1,00,000, since the coupon and the redemption amount are fixed
- b)It rises above ₹1,00,000, since investors now demand more
- c)It falls below ₹1,00,000, since the fixed cash flows are discounted at a higher rate
- d)It falls to ₹90,000 exactly, in line with the 1% change in rates
Show the answer
Answer: (c) It falls below ₹1,00,000, since the fixed cash flows are discounted at a higher rate
This is the workbook's own introduction to discounted cash flow. "The value of the bond is the present value of all the future cash flows discounted at prevailing interest rates." When the coupon and the expected rate are both 9%, the value "would turn out to be face value viz Rs. 100,000."
Then the rule: "If expected rate of return by investors is higher (lower) than 9%, then bond would have value less (more) than Rs. 100,000." The cash flows stay the same, but each one is divided by a bigger discount factor, so their present value falls. The chapter's first sample question checks the same thing: if interest rates in the economy rise, the price of the bond falls.
Why the others are wrong:
- Option A confuses fixed cash flows with a fixed value. The amounts are fixed, but what they are worth today depends on the rate.
- Option B has the direction backwards. A higher required return means a lower price.
- Option D invents a precise one-for-one rule. The workbook gives only the direction here, and a 1% change in the rate does not cut the price by exactly 10%.
The chapter then applies the same idea to equity. Coupons become dividends and redemption becomes sale proceeds. The difference is that for equity "quantum of cash flows (dividends or sales price) and their timings are unknown and uncertain."
2.Besides the perpetual growth model, what other method does the workbook allow for calculating a terminal value?
- a)Adding up the undiscounted cash flows of the high growth phase
- b)Multiplying EBITDA (or EBIT) at the end of the high growth period by an appropriate EV/EBITDA (or EV/EBIT) multiple taken from comparable firms
- c)Using the book value of equity at the end of the forecast period
- d)Multiplying the final year's dividend by the cost of equity
Show the answer
Answer: (b) Multiplying EBITDA (or EBIT) at the end of the high growth period by an appropriate EV/EBITDA (or EV/EBIT) multiple taken from comparable firms
The workbook's alternative: "terminal value can also be calculated by taking into consideration expected sale value of the business at the end of high growth phase. This is typically done by multiplying EBITDA (or EBIT) at the end of the high growth period by the appropriate EV/EBITDA (or EV/EBIT) multiple. The multiple is decided based on that of comparable firms."
That links the two halves of the chapter. The DCF borrows a relative valuation multiple for its final stage.
Whatever method is used, one rule still applies: "The terminal value is added to the cash flows for the growth or projection period, and then discounted to the present value."
Why the others are wrong:
- Option A adds up the forecast years. It says nothing about value beyond them, and it ignores discounting completely.
- Option C uses a historical-cost balance sheet figure. That is not a sale value, and the workbook warns that for capital-intensive firms book values "often do not reflect the fair value".
- Option D is not a valuation formula. Multiplying a cash flow by a rate gives a smaller cash flow, not a capital value.
3.According to the workbook’s comparison of technical and fundamental analysis, which pairing is correct?
- a)Technical analysis — uses historic price and volume data, is geared to short/medium-term trading strategies, and is followed by traders, chartists, speculators and short-term investors
- b)Technical analysis — assumes that market prices may at times deviate from their intrinsic values
- c)Fundamental analysis — its objective is to forecast price movements and trading opportunities
- d)Fundamental analysis — its main tools are chart patterns and indicators such as RSI, MACD and OBV
Show the answer
Answer: (a) Technical analysis — uses historic price and volume data, is geared to short/medium-term trading strategies, and is followed by traders, chartists, speculators and short-term investors
The workbook’s comparison table lines up each feature. For technical analysis: data source — "historic price and volume data"; time horizon — "short/medium term trading strategies"; followed by — "traders, chartists, speculators, short-term investors". Option A combines three rows correctly.
The others take a row from one column and hang it on the other. Option B is the fundamental assumption — "at times market prices may deviate from their intrinsic values"; the technical assumption is that the "current market price captures all the information; trend is likely to continue". Option C is the technical objective; fundamental analysis aims to "identify undervalued or overvalued assets". Option D lists the technical toolkit; the fundamental tools are "cash flow statements, DCF valuation, SWOT analysis, ratio analysis", and fundamental analysis is followed by "fund managers, portfolio managers, value investors, long-term investors".
Where this is taught
- Series XIX-A · Chapter 11: Valuationintroduced here
- Series XV · Chapter 10: Valuation Principlesintroduced here
- Series XIX-C · Chapter 14: Valuationintroduced here
- Series XIX-D · Chapter 11: Valuationintroduced here
- Series X-A · Chapter 8: Investing in Stocksintroduced here
- Series XXI-A · Chapter 3: Investing in Stocksintroduced here
Related terms
- CAPMA model that prices the return an investor should demand from a share: the risk-free rate plus beta times the market risk premium.
- Dividend Discount ModelA valuation that treats a share as worth the present value of every dividend it will ever pay, discounted at the return an equity investor demands for holding it.
- Enterprise ValueWhat it would cost to buy the whole business — market capitalisation plus debt, less cash — as opposed to market capitalisation, which buys only the equity.
- Free Cash Flow to EquityThe cash left for shareholders after operating costs, tax, capital expenditure, working capital needs and all payments to lenders — what could be paid out as dividend without harming the business.
- Intrinsic valueWhat an asset is actually worth — the present value of the cash it will generate over its remaining life, as against whatever price the market is quoting today.
- Margin of safetyThe gap between a security's estimated intrinsic value and the lower price paid for it — the cushion that protects the buyer when the estimate turns out to be wrong.
- Unaffected share priceA target company's share price before a merger or acquisition is announced — the base over which an acquirer must pay a premium, and the price a merger arbitrageur measures the spread from.
- Sunrise sectorsNewly emerging sectors around which AIF investment themes are being built — new-generation technologies and ESG, including AI, virtual and artificial reality, green energy and sustainability.
- WACCThe blended after-tax rate a company pays on all its capital, equity and debt weighted by how much of each it uses — and therefore the discount rate for free cash flow to the firm.
- Free Cash Flow to FirmThe cash a business generates before any payment to any provider of capital — discounted at WACC it gives the value of the whole firm, from which debt and other claims are then subtracted.
- Terminal valueThe value of everything a business earns after the end of the explicit forecast period, capitalised as a perpetuity or an exit multiple and then discounted back — usually most of a DCF answer.
- Relative valuationValuing an asset from the prices of comparable assets rather than from its own cash flows — quick, intuitive, and dependent on whoever set those comparable prices being right.
- Fundamental analysisEstimating what a share is worth from the profits and cash flows the business will generate, then buying only when the market price sits below that estimate.
- Sensitivity analysisChanging one critical input of a valuation model at a time, holding the rest constant, and tabulating how far the output value moves — a test of how fragile the answer is.
- Operating Cash FlowCash actually generated by a business's core operations — profit after tax with non-cash charges added back and working capital movements adjusted, before any capital expenditure.
- Market approachValuing a business from what the market pays for comparable businesses, using earnings and market multiples rather than the company's own projected cash flows.
- Cost approachValuing a business from its assets less its liabilities — by book value, by what it would cost to replace, or by what it would fetch if broken up and sold.
- Deal CompsRelative valuation using earnings based multiples — chiefly EV/EBITDA and EV/Sales — which the workbook also calls Transaction Comparables.
- Present Value (PV) factorThe multiplier that converts a single future amount into today's value: 1 ÷ (1 + r)^n. At 14% for 8 years it is 0.351, so Rs 100 due then is worth Rs 35.10 now.
- Economic profit approachA business valuation approach in which value is the capital presently employed in the business plus the present value of the economic profit it is projected to earn in future.
- Contingent claim valuationA business valuation approach that puts an option pricing model inside a cash flow based valuation, so that the real options embedded in a business are given a value instead of being ignored.
- Price to Earnings multipleShare price divided by earnings per share — the workbook's most widely used market multiple, and a trading comp an AIF can apply to an unlisted company only through its listed peers.
- Cost based valuationValuing an asset by what it would cost to build it from scratch today, rather than by its cash flows or the price of comparable assets — mainly used by strategic, not financial, investors.
- Risk neutral valuationA cash-flow valuation method that adjusts expected cash flows for the probability of actually receiving them, then discounts the result at the risk-free rate — used mainly for insurers.
- Embedded valueFor a life insurer, the present value of the expected net future cash flow — adjusted for probability — from the policies currently in force, used as the base of a Price/Embedded value multiple.
- IPEV GuidelinesThe international best-practice guidelines for valuing unlisted private equity and venture capital investments at fair value, setting out seven widely used methods for valuing a portfolio company.
- Country Risk PremiumThe extra return an investor demands for putting money into one country rather than another, added to the required rate of return to pay for that country's political and macroeconomic risk.
- Non-financial multiplesA valuation multiple built on an operating number instead of profit — gross merchandise value in e-commerce, average revenue per user in telecom, average room revenue in hotels.
- Equity ValueThe value of 100% of a company's shares — what belongs to equity shareholders after debt and preference capital are deducted from enterprise value. For a listed company, its market capitalisation.
- Replacement Cost ApproachAn asset-based valuation that values a business at what it would cost to replace it as it stands today, including set-up costs — suited to businesses with high entry barriers or setting-up costs.
- Present Value Annuity FactorThe number that converts a level stream of equal payments for n periods into its present value at rate r: PVA(n, r) = (1 − (1 + r)^−n) / r. Used with the PV factor to value bonds.
- Free Cash FlowThe cash a company generates from operations after reinvesting in working capital and routine capital expenditure — the figure a DCF valuation projects for about five years and discounts at WACC.
- Terminal Growth RateThe constant rate at which free cash flow is assumed to grow forever after the explicit forecast period — the "g" in terminal value = FCF(T+1) / (WACC − g). In young companies it can drive most of the value.
- Price of Previous Transaction MethodAn IPEV valuation method that marks an AIF's whole holding in a company at the price of its latest follow-on investment; a first investment is carried at cost until a follow-on reprices it.
- Intrinsic value of a bondThe sum of the present values of all a bond's future cash flows, discounted at the investor's required rate of return. Buy if it exceeds the market price; sell if it is below.