Building a DCF, step by step

A discounted cash flow — a DCF — has a fearsome reputation. It sounds like something only a spreadsheet-wielding analyst can do. In truth it is three plain moves, and by the end of this module you will have done all three on real ₹ numbers, by hand.

The three moves are: forecast the free cash flow for a handful of years; discount each year back to today's value; and add a terminal value for all the years after your forecast ends. That's it. Everything else is detail. The maths uses nothing harder than multiplication and division. What makes a DCF hard is not the arithmetic — it is the honesty of the assumptions you feed it, which is the subject of the next several modules. Here, we just build one cleanly so you can see how the machine works.

Why not just forecast cash flow forever? Because you cannot. Nobody can sensibly predict a company's cash in year 27. So a DCF splits a company's future into two stages, and this two-stage DCF is the workhorse of the whole method.

• Stage one — the explicit forecast. For a manageable window, usually five to ten years — the explicit forecast period — you forecast free cash flow year by year, using a growth rate you can defend.
• Stage two — the terminal value. After the forecast ends, you stop guessing year by year and instead put a single value on everything that comes after, assuming the business settles into slow, steady, mature growth. This lump is the terminal value.

The two stages mirror how real businesses live: a period of faster, forecastable growth, then a long mature tail. We will run the whole thing on one composite company. illustrative Its free cash flow this year is ₹100 crore. We judge it can grow that cash at 10% a year for five years, then settle to 4% a year forever. We discount everything at a 12% rate. Those four numbers — starting cash, near-term growth, long-term growth, discount rate — are the entire input set.

Move one — forecast the cash. Grow ₹100 crore at 10% for five years:

Move two — discount each year. The discount factor for year n is 1 ÷ (1.12)ⁿ. Year 1 is 1 ÷ 1.12 = 0.893; year 5 is 1 ÷ 1.12⁵ = 0.567. Multiply each year's cash by its factor and you get its present value — what that future rupee is worth today. Add the five present values: ₹473.9 crore. That is stage one, done.

Move three — add the terminal value. After year five, we assume the ₹161.1 crore of year-5 cash grows at a steady 4% forever. There is a tidy formula for the value, at year five, of a cash flow growing forever — the perpetuity formula. The discount rate we use, 12%, stands for the return we demand for the risk; the growth we assume, 4%, is roughly long-run economy-like growth. The terminal value at the end of year five is:

Terminal value = (Year-5 FCF × 1.04) ÷ (0.12 − 0.04) = (161.1 × 1.04) ÷ 0.08 = 167.5 ÷ 0.08 = ₹2,094 crore

But that ₹2,094 crore sits five years out, so it too must be discounted to today: ₹2,094 crore × 0.567 = ₹1,188 crore.

Add the two stages:

Value of the business = ₹473.9 cr (stage one) + ₹1,188 cr (terminal) ≈ ₹1,662 crore

With no net debt and, say, 10 crore shares, that is ₹1,662 cr ÷ 10 cr ≈ ₹166 per share. You have just built a DCF. This is value as the discounted stream of future cash made concrete in rupees.

Sit with what the picture just showed you, because it is the most important lesson of the whole module. The five forecast years — the part you worked hardest on, the part that felt like "the analysis" — added up to only ₹474 crore, about 28% of the value. The single terminal-value bar, resting on one assumption about growth after year five, is ₹1,188 crore — roughly 72% of the answer.

Read that again. Nearly three-quarters of this company's estimated worth comes not from the years you carefully forecast, but from one line about the far future you cannot see. This is not a quirk of our numbers; it is true of almost every DCF, and it is exactly why the next module is devoted to it.

It also reframes what a DCF is. It is not a machine that measures value. It is a machine that makes your assumptions explicit and shows you their consequences. Change the inputs and the ₹166 moves. That is a feature, not a bug — but only if you treat the output as a considered estimate rather than a reading off a dial.

The clean output hides how much rests on soft ground.

It cannot tell you it is right. ₹166 is the arithmetic consequence of four assumptions. If the growth or the discount rate is wrong — and at least one of them will be — the output is wrong too, and just as precise-looking.

It cannot tell you where the value came from. A single per-share number conceals that 72% of it sits in the terminal value, resting on a long-run growth guess. Two DCFs printing the same ₹166 can have utterly different fragilities underneath.

It cannot rank a growth business against a steady one honestly unless the assumptions are held to the same discipline. It is easy — and common — to feed a favoured company generous growth and a gentle discount rate, and a disliked one the reverse, and call the result "the numbers".

1. Quoting the output to the rupee. ₹166.00 feels like a measurement. It is the midpoint of a wide, blurry range. Round it, and treat a small gap to the market price as noise.

2. Forgetting to discount the terminal value. The terminal value is computed at year five and must itself be pulled back to today. Skipping that step massively overstates value.

3. Ignoring net debt and share count. The two present values give the business value. Subtract net debt (or add net cash), then divide by shares, to reach a per-share figure. Beginners often stop one step too early.

4. Letting the terminal growth rate creep up. A terminal growth of 8% quietly assumes the company outgrows the economy forever — impossible. Small changes here move the answer enormously, as the next module shows.

5. Mistaking effort for accuracy. The five years you laboured over are the small part of the answer. The one line you dashed off — terminal growth — is the big part. Effort and importance are inverted.