Reverse DCF: what the price already assumes

A normal DCF starts with your forecasts and ends with a value. A reverse DCF runs the other way. It starts with the price the market is paying today and asks what the future would have to look like to justify it.

This changes the question you are answering. Instead of defending a growth forecast that nobody can verify, you can say: the current price assumes free cash flow grows about 21% a year for ten years. Is that realistic for this business? You can judge that against the company's own history, its industry and its best competitors far more easily than you can build a forecast from nothing.

A reverse DCF does not tell you what a company is worth. It tells you what the price already assumes, so you can decide whether those expectations are too high, about right or too low.

The steps

1. Start with the market's value. Take market capitalisation and add net debt (borrowings minus cash) to get enterprise value. A DCF of free cash flow to the firm values the whole business, not only the equity.
2. Fix everything except growth. Choose a discount rate (WACC), a forecast period (often ten years), a terminal growth rate and the current free cash flow. Use the same assumptions you would use in a normal DCF.
3. Solve for growth. Change the growth rate until the DCF value equals the enterprise value. In Excel, Goal Seek does this in one step: set the DCF value cell to the enterprise value by changing the growth cell.
4. Judge the answer. Compare the implied growth with what the company has delivered over the last five to ten years, with growth in its industry and with what its strongest competitors achieve.

Illustrative example

A hypothetical company has free cash flow of ₹100 crore this year, no debt, no surplus cash and a market capitalisation of ₹5,000 crore, which is 50 times its free cash flow. Assume a WACC of 12%, a ten-year forecast and terminal growth of 5% a year after year 10.

At about 21.5% a year, free cash flow rises from ₹100 crore to about ₹702 crore by year 10. Of the ₹5,000 crore value, about ₹1,609 crore comes from the ten forecast years and about ₹3,391 crore, roughly two-thirds, from the terminal value.

So the price assumes free cash flow grows above 20% a year for a decade and then keeps growing. Whether that is reasonable depends on the business, but you now have a specific claim to test.

A quicker single-stage check

With one growth rate forever, the perpetuity formula can be rearranged. Value = Next year's free cash flow ÷ (WACC − g), so g = WACC − (Next year's free cash flow ÷ Value). Treat the same ₹100 crore as next year's free cash flow: against a value of ₹5,000 crore and a WACC of 12%, implied perpetual growth is 12% − 2% = 10%. This is a useful sanity check, but a two-stage model is closer to how businesses actually grow.