How to Value a Company Using a Discounted Cash Flow Model

A Story Written in Numbers

Many people treat a DCF as a machine. Put in numbers, get out a "fair value." When the answer looks wrong, they adjust the inputs until it looks right.

A better way to see a DCF is as a story about a business, written in numbers. How fast will it grow? How profitable will it be? How much must it invest to grow? How risky is it? Each input is one sentence of that story. If the story does not hold together, the value will not either.

This walk-through builds a simple DCF for one illustrative company.

Step 1: Start From the Business

Before opening a spreadsheet, write a short paragraph about the company: its market, its position, how long its growth can last and what margins it can sustain. Every number that follows should trace back to that paragraph.

Illustrative company. A mid-sized Indian manufacturer with revenue of ₹1,000 crore. Demand in its market is growing fast, but competition will slow that growth over time. Its operating margin is 15% and can improve a little with scale.

Step 2: Forecast Free Cash Flow to the Firm

Free cash flow to the firm (FCFF) is the cash the business generates after tax and reinvestment, before paying lenders or shareholders.

FCFF = EBIT × (1 - Tax rate) - Reinvestment

Reinvestment is net capex (capex minus depreciation) plus the increase in working capital. A simple way to estimate it is the sales-to-capital ratio: how many rupees of revenue each rupee of new capital supports. Here, every ₹2 of new revenue needs ₹1 of new capital.

Assumptions:

• Revenue growth of 15%, 14%, 12%, 10% and 8% over five years.
• Operating (EBIT) margin rising from 15% to 16%.
• Tax rate of 25%.
• Sales-to-capital ratio of 2.0.

Free cash flow is far below profit in the early years. The company is paying for its growth.

Step 3: Choose the Discount Rate

FCFF belongs to both lenders and shareholders, so it is discounted at the weighted average cost of capital, or WACC. Here we use 12%.

The present value of the five years adds up to ₹333.9 crore.

Step 4: Estimate the Terminal Value

After year 5, assume the company grows 5% a year forever. Growth needs reinvestment, so assume the return on new capital settles at 15%. That means reinvesting 5% ÷ 15%, or one-third, of after-tax operating profit each year.

• After-tax EBIT in year 6: 209.3 × 1.05 = ₹219.8 crore
• FCFF in year 6: 219.8 × (1 - 1/3) = ₹146.5 crore
• Terminal value at the end of year 5: 146.5 ÷ (12% - 5%) = ₹2,093 crore
• Present value of the terminal value: 2,093 × 0.567 = ₹1,188 crore

Step 5: From Enterprise Value to Value per Share

In a real company, the bridge from enterprise value to equity value usually has more items:

• Add investments and assets not used in the business.
• Subtract lease liabilities, if your cash flows treat lease payments as financing rather than operating costs.
• Subtract minority interest, the share of subsidiaries owned by others.
• Subtract preference capital and other debt-like claims, such as large unfunded employee obligations.
• Adjust for employee stock options that will add new shares.

Sanity Checks Before You Trust the Answer

1. Terminal value share. Here it is 78% of enterprise value. That is common for a five-year model, but it means the long-run assumptions carry most of the weight.
2. Implied multiple. The terminal value is about 9.5 times year-6 after-tax operating profit. Check whether a mature company in this sector could plausibly trade near that.
3. Consistent returns. In the forecast, each ₹1 of new capital supports ₹2 of revenue at a 16% margin, an after-tax return of 24%. The terminal assumption of 15% builds in a fade as competition catches up. That fade should be deliberate, not accidental.
4. Sensitivity. Show value across a range of WACC and terminal growth, not one number.
5. Reverse DCF. Compare your value with the market price. If they are far apart, work out what growth or margin the market price implies, and judge which story is more realistic.

Mistakes That Show Up Again and Again

• Mixing cash flows and discount rates. FCFF goes with WACC. Free cash flow to equity goes with the cost of equity. Mixing them gives a wrong answer.
• Treating EBITDA as cash. EBITDA ignores tax, capex and working capital.
• Growth without reinvestment. Raising growth without raising reinvestment assumes something for nothing.
• Skipping the debt bridge. Dividing enterprise value by the number of shares, without subtracting debt, overstates value per share.
• Ignoring dilution. Employee stock options are a real cost to existing shareholders.

The Reframe

A DCF does not tell you what a company is worth. It tells you what it is worth if your story is right. The real work is making the story worth believing.