Chapter 11 of 15
How to Value a Stock (DCF)
Discounted Cash Flow - finding intrinsic value.
Rahul was looking at two cricket bats. Both were SG. Both were English willow. One was ₹3,500. One was ₹8,000.
He didn't just ask "which is cheaper?" He asked: what explains the price difference? Grain count? Pressing? Weight? Performance record of the same bat design in professional matches?
He brought that same mindset to stocks. "The share price is ₹2,400. Is that expensive? Cheap? How would I even know?"
This is the valuation question. And most retail investors get it completely wrong, they assume a "low price" stock is cheap and a "high price" stock is expensive. That's like saying a ₹100 bat is always a deal and a ₹10,000 bat is always overpriced. Nonsense.
What Is Stock Valuation?
Intrinsic value is what a stock is actually worth based on the business's fundamentals, its earnings, growth potential, and risk, independent of what the market currently prices it at. When market price is below intrinsic value, the stock may be undervalued.
The core idea behind value investing (Buffett, Graham, etc.): stocks have an intrinsic value that you can estimate. Buy when the market price is significantly below intrinsic value ("margin of safety"). Sell when the market price approaches or exceeds intrinsic value.
The challenge: intrinsic value is always an estimate, not a precise number. Two analysts valuing the same company can reach very different conclusions. That's fine, the goal is a reasonable range, not a perfect figure.
Method 1: Relative Valuation (P/E Comparison)
The fastest and most commonly used method: compare the stock's valuation ratio to peers.
Step 1: Find the company's current P/E ratio (price ÷ EPS).
Step 2: Find the average P/E of similar listed companies in the same sector.
Step 3: Compare. If the company's P/E is significantly below peers for no good reason, it could be undervalued. If it's significantly above peers, it needs a compelling growth story to justify the premium.
Rahul looks at four mid-sized IT companies: Company A: P/E 22. Company B: P/E 18. Company C: P/E 28. Company D: P/E 14. Sector average: 22. Company B at 18× looks modestly undervalued, unless it's growing slower than peers. Company D at 14× looks very cheap, or something is wrong. Company C at 28× needs to be growing faster than the sector to justify the premium. The P/E alone doesn't decide. Rahul then checks revenue growth and ROE for each.
Limitations of P/E comparison:
- Works poorly for companies with volatile or negative earnings
- Can mislead if the entire sector is overvalued or undervalued
- Doesn't account for company-specific growth rates
Method 2: PEG Ratio (P/E Adjusted for Growth)
PEG = P/E Ratio ÷ Earnings Growth Rate. It adjusts the P/E for growth, making it easier to compare fast-growing and slow-growing companies. A PEG of 1 is roughly fairly valued; below 1 may be undervalued.
Example: Company with P/E of 30 and EPS growing at 30% per year → PEG = 30 ÷ 30 = 1.0. Fairly valued. Company with P/E of 30 but EPS growing at 15% → PEG = 30 ÷ 15 = 2.0. Possibly overvalued. Company with P/E of 15 and EPS growing at 20% → PEG = 15 ÷ 20 = 0.75. Potentially undervalued.
PEG is a quick shortcut. It has weaknesses (growth estimates can be wrong; it doesn't account for risk), but it's a useful first filter.
Method 3, DCF (Discounted Cash Flow), The Fundamental Approach
DCF estimates a company's value by projecting its future free cash flows and discounting them back to today's value (since future money is worth less than present money). The sum of all discounted cash flows is the intrinsic value.
The logic comes from a simple truth: ₹100 today is worth more than ₹100 three years from now. If you could earn 10% in an FD, ₹100 today becomes ₹133 in 3 years, so ₹133 in 3 years is worth only ₹100 today. That's discounting.
DCF applies this to a company's future profits.
Simple DCF framework:
- Project free cash flow (FCF): Estimate what the business will generate in net cash over the next 5–10 years.
- Choose a discount rate: Typically 10–15% for Indian equities (reflecting the opportunity cost, what you could earn in alternatives + risk premium).
- Calculate terminal value: Estimate the business's value at the end of your projection period (often based on a terminal growth rate of 3–5%).
- Sum and discount: Add up all future FCFs and terminal value, discounted to today's value.
Rahul looks at a consumer goods company currently earning ₹100 crore in free cash flow. He estimates 15% FCF growth for 5 years, then 8% for the next 5 years, then a terminal growth rate of 5%. He uses a 12% discount rate (reasonable for a stable Indian consumer company). Without building a complex model, he estimates the intrinsic value to be roughly ₹1,800–2,200 crore. The current market cap is ₹1,500 crore. There's a potential 20–47% upside. That's a margin of safety he finds interesting, now he digs deeper to validate his growth assumptions.
Change the discount rate from 12% to 14%, and the DCF value drops 20–25%. Change the growth rate assumption from 15% to 12%, and it drops again. DCF is a framework for thinking through value, not a precise calculator. Always use a range of assumptions (bull/base/bear case) and treat the output as a range, not a single number. Rahul treats DCF as a "sanity check," not a buy signal.
Margin of Safety: The Most Important Concept in Valuation
Margin of safety is the gap between a stock's estimated intrinsic value and its current market price. Buying at a significant discount to intrinsic value protects you when your analysis turns out to be slightly wrong.
Benjamin Graham's principle: even if you're confident in your valuation, buy at a discount. If you think a stock is worth ₹100, don't pay ₹95. Pay ₹65–70. The gap is your protection against your own estimation errors.
In Indian markets, patient investors who buy quality stocks at 20–35% discount to estimated intrinsic value and hold for 3–5 years have historically done very well. The hard part is waiting for the discount, which sometimes requires markets to crash.
When Is a Stock "Too Expensive"?
A stock is expensive not because the absolute price is high, but because:
- The growth implied in the current price is unrealistic (P/E of 80× for a company growing at 10%)
- The market is pricing in a best-case scenario with no room for error
- Every piece of good news is already in the price (called "priced to perfection")
A stock is cheap when:
- A temporary problem (bad quarter, sector headwind, market crash) has caused selling
- The problem is solvable, and the underlying business quality is intact
- The valuation multiples have compressed below historical averages for no fundamental reason
| Valuation Method | Best Used For | Main Weakness |
|---|---|---|
| P/E Comparison | Quick peer comparison within sector | Doesn't account for growth rates or debt |
| PEG Ratio | Comparing growth companies | Growth estimates can be very wrong |
| P/B Ratio | Banks and asset-heavy companies | Doesn't reflect earnings power |
| EV/EBITDA | Capital-intensive or highly leveraged companies | Requires understanding of debt structure |
| DCF | Long-term intrinsic value estimate | Very sensitive to assumptions |
Professional analysts rarely use only one valuation method. They build multiple approaches, triangulate, and see where they converge. If DCF says ₹1,800 crore, P/E comparison says ₹1,600–2,000 crore, and EV/EBITDA says ₹1,700 crore, the convergence around ₹1,700–1,800 crore gives confidence. Divergence forces you to think harder about which method fits this business better.
Key Takeaways
- Intrinsic value is what a stock is actually worth based on fundamentals: market price can be above or below it
- P/E comparison is the fastest method: but only compare within the same sector
- PEG ratio adjusts P/E for growth rate: PEG below 1 may indicate undervaluation
- DCF discounts all future cash flows to today's value: powerful but highly sensitive to assumptions
- Margin of safety: buy significantly below estimated intrinsic value to protect against errors
- A stock is cheap or expensive based on growth-adjusted valuation, not just the rupee price per share
Learn how technical analysis adds a different lens on timing, or explore building a long-term portfolio where these valuation principles come together.
Rahul estimates a company's intrinsic value at ₹1,000 crore. The market cap is currently ₹700 crore. What is the margin of safety and what should he do?
Disclaimer: This article is for educational purposes only and does not constitute personalized financial advice. Investments are subject to market risks. Past performance does not guarantee future returns. Please consult a SEBI-registered investment adviser before making investment decisions.