DCF valuation explained: how to value an Indian company from first principles

What is a DCF valuation?

Discounted cash flow valuation is the most theoretically grounded way to estimate the intrinsic value of a business. The idea is older than modern finance — Irving Fisher formalised it in 1930, John Burr Williams popularised it in 1938, and Warren Buffett has called it the only logical way to value any productive asset. The intuition is simple. A business is worth the present value of all the cash it can be expected to distribute to its owners between today and judgment day. To translate that idea into a number, an analyst projects free cash flow for an explicit forecast horizon, estimates a terminal value for everything after that horizon, and then discounts all of those future amounts back to today using a required rate of return.

For an Indian retail investor staring at a Nifty 50 stock, DCF answers a specific question: what would I have to pay today, given prevailing interest rates and the riskiness of this business, so that the future rupees this company is illustratively expected to generate would earn me a fair return on my capital? If the share price quoted on NSE is materially below that number, the stock is observed to trade at a discount to a model of intrinsic value. If it is materially above, the stock is observed to trade at a premium.

The three inputs that drive every DCF

Every DCF model, regardless of how complex the spreadsheet looks, rests on exactly three inputs: the free cash flow forecasts, the discount rate, and the terminal value. Get these three right and the model is useful. Get any one of them badly wrong and the output is junk regardless of how detailed the supporting tabs appear.

Free cash flow is the cash a business generates after paying for everything required to keep it operating and growing — operating expenses, taxes, capital expenditure on plant and equipment, and the working capital tied up in inventories and receivables. The discount rate, typically the weighted average cost of capital (WACC), translates future rupees back to today and embeds both the time value of money and the risk that future cash flows may not arrive as forecast. The terminal value captures the value of the business beyond the explicit forecast horizon, usually built using the Gordon Growth model, which assumes a constant perpetual growth rate forever after the projection period.

Step 1: Forecast free cash flow

Free cash flow to the firm (FCFF) is built from the income statement and cash flow statement. The standard formula is: EBIT multiplied by one minus the effective tax rate, plus depreciation and amortisation, minus capital expenditure, minus the change in non-cash working capital. The first term is the operating profit the business historically generated. Adding back D&A converts accrual profit into a cash measure. Subtracting capex removes the cash spent on long-lived assets. Subtracting working capital changes removes the cash that is illustratively trapped in higher inventories and unpaid customer invoices as the business grows.

For an explicit five to ten year forecast, the analyst builds each component from the top down. Revenue is projected using historical growth rates, management guidance, and a view on industry growth. EBIT margins are projected based on historical margin behaviour, operating leverage, and competitive dynamics. Capex is projected using historical capex-to-sales ratios for capacity-constrained businesses or bottom-up project pipelines for capital-heavy firms. Working capital is projected using historical days-of-sales metrics for receivables, inventory, and payables.

Take an illustrative IT services firm with ₹2,40,000 crore revenue today, a historical 9 percent revenue CAGR, EBIT margins around 24 percent, capex roughly 2 percent of revenue, and effective tax of 26 percent. Year one FCFF would be observed at roughly ₹47,000 crore on a stylised model. Project that out for ten years tapering growth from 9 percent in year one to 5 percent in year ten, and the explicit forecast period yields a stream of free cash flows that can each be discounted to present value.

Step 2: Calculate WACC for an Indian company

The discount rate is the most commonly mispriced input in retail DCFs. WACC blends the cost of equity and the cost of debt in proportion to how the company is financed. For Indian companies in 2026, illustrative cost of equity components are typically: a risk-free rate equal to the 10-year G-Sec yield (historically in a band around 6.5 to 7.5 percent), an India equity risk premium in the 6 to 7 percent range that reflects the additional return investors have historically required for emerging-market equity risk, and a beta that captures the stock's volatility relative to the broader market. A defensive consumer staple typically has a beta below one, while a high-beta cyclical may sit at 1.2 or higher.

Putting those together via the capital asset pricing model — cost of equity equals risk-free rate plus beta times equity risk premium — yields illustrative cost-of-equity figures around 12 to 14 percent for a typical large-cap Indian stock. The cost of debt is the after-tax marginal borrowing rate, often inferred from the company's interest expense divided by average debt outstanding, then multiplied by one minus the marginal tax rate. WACC is then the weighted average using the market value of equity and debt as weights. For most large-cap Indian companies the resulting WACC sits historically in the 11 to 14 percent range.

Step 3: Calculate terminal value

Terminal value typically accounts for 60 to 80 percent of the intrinsic value calculated in a DCF, which makes the choice of terminal-growth assumption disproportionately important. The Gordon Growth model is the standard approach: terminal value at the end of year N equals year N+1 free cash flow divided by WACC minus the perpetual growth rate. For India, a defensible perpetual growth rate sits at 4 to 5 percent — broadly in line with long-run inflation plus a small real growth premium, and well below long-run nominal GDP growth so the company does not eventually consume the entire economy.

Using the illustrative IT services example with year ten FCFF of roughly ₹78,000 crore, a terminal growth rate of 4.5 percent, and a WACC of 12 percent, the terminal value at the end of year ten is approximately ₹10,84,000 crore. Discounting that back to today using ten years of 12 percent compounding yields a present value of roughly ₹3,49,000 crore. Adding the present value of the explicit-period cash flows produces the enterprise value, from which net debt is subtracted to arrive at equity value, and dividing by the share count gives an illustrative per-share intrinsic value.

Step 4: Sensitivity analysis

The single most important deliverable in any DCF is not the central per-share number but the sensitivity grid surrounding it. Build a two-variable data table with WACC across the top in 0.5 percent steps from 10 to 14 percent, and terminal growth rate down the side from 3 to 5 percent. Each cell holds the implied per-share value. The grid almost always shows a wide band — for the IT services example above, a swing from a 14 percent WACC and 3 percent terminal growth to a 10 percent WACC and 5 percent terminal growth can change the per-share value by 80 percent or more.

That dispersion is not a bug. It is the model honestly reporting how much of valuation depends on inputs that nobody can know with precision. Sophisticated practitioners look at the band rather than a point estimate, ask whether the current market price falls inside or outside the band, and demand a margin of safety before treating the model as a useful signal.

DCF for different industries

Software and IT services firms are among the friendliest candidates for DCF — capex is light, working capital is predictable, margins are stable, and revenue growth is gradual rather than discontinuous. The standard DCF works well historically for firms like the large-cap Indian IT services majors.

Banks and NBFCs are a poor fit for traditional DCF because their balance sheet is the business — capital expenditure is not a clean concept, and free cash flow is dominated by changes in advances and deposits. Practitioners use a residual income or dividend discount model instead, valuing the franchise based on return on equity above the cost of equity.

Commodity and cyclical businesses such as metals, chemicals, oil and gas, and cement are difficult because earnings swing wildly with commodity cycles. A normalised mid-cycle DCF works better than a peak-earnings DCF, and the analyst should use a mid-cycle EBIT margin assumption rather than the trailing twelve months. High-growth and loss-making firms require a multi-stage DCF with explicit break-even modelling, and the answer is typically more sensitive to the path of margin expansion than to terminal value.

Common DCF mistakes Indian retail investors make

The first and most common mistake is over-optimistic revenue growth. A projection that has any company growing at 20 percent for ten straight years is mathematically extending a startup-stage growth rate into perpetuity. Historical Indian large-caps have rarely sustained more than 12 to 15 percent revenue growth across a full decade.

The second mistake is ignoring or under-modelling capital expenditure. A model that uses depreciation as a proxy for capex implicitly assumes the firm never builds new capacity, which is unrealistic for any growing business. Capex must be modelled explicitly as a function of revenue or capacity additions.

The third mistake is using the wrong discount rate. A WACC of 8 percent applied to an Indian equity is mathematically a near-zero equity risk premium, which contradicts every long-run dataset on Indian equity returns. Conversely, a WACC of 18 percent for a stable consumer staple ignores the lower-than-market beta of those firms.

The fourth mistake is double-counting growth. If the explicit forecast period already captures all of the high-growth phase, terminal value should reflect a mature, slow-growing business — not another decade of high growth bolted on. Many retail DCFs end up implicitly assuming forty years of compounding double-digit growth, which has never been observed in any real company over that horizon.

The fifth mistake is false precision. A per-share value to the rupee gives the illusion of accuracy that the inputs cannot support. Practitioners discuss DCF outputs in ranges, not points.

Putting DCF in context with other valuation tools

DCF is a powerful framework but it is not the only valuation tool. It should be triangulated against the P/E ratio of comparable companies, the EV/EBITDA multiple, the price-to-book ratio for asset-heavy businesses, and the dividend discount approach for mature payers. A DCF that produces a per-share value four times higher than the median peer multiple is either flagging a genuine mispricing or signalling that the inputs are too aggressive. In either case, the analyst should reconcile the difference rather than ignore it.

A solid grasp of the cash flow statement is non-negotiable for building a credible DCF — the entire model flows from operating cash flow and capex disclosures. For a back-of-envelope check on whether long-term compounding assumptions are realistic, the CAGR calculator is a quick sanity tool.

Frequently asked questions

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