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Chapter 11 of 15

How to Value a Stock (DCF)

Discounted Cash Flow — finding intrinsic value.

18 min read Chapter 11

Priya had shortlisted three companies she admired fundamentally. But all three seemed expensive based on their current P/E ratios. Her mentor introduced her to DCF — Discounted Cash Flow analysis. "The stock market gives you a vote every day," her mentor said, quoting Benjamin Graham, "but it gives you a weighing machine over the long term. DCF is how you figure out what a business actually weighs."

What Is Intrinsic Value?

Intrinsic Value:

The intrinsic value of a stock is its true underlying worth based on the company's ability to generate future cash flows — independent of its current market price. If a stock's market price is below its intrinsic value, it may be undervalued (a potential opportunity). Above intrinsic value — overvalued (potential risk).

DCF (Discounted Cash Flow):

DCF is a valuation method that estimates a company's intrinsic value by projecting its future free cash flows and "discounting" them back to today's value using an appropriate discount rate. The idea: ₹100 today is worth more than ₹100 received 5 years from now.

WACC (Weighted Average Cost of Capital):

WACC is the average rate a company pays to finance its assets, weighted by the proportion of debt and equity in its capital structure. It is used as the discount rate in DCF analysis. For most Indian companies, WACC typically ranges from 10–14%.

Margin of Safety:

The margin of safety is the difference between a stock's intrinsic value and its current market price, expressed as a percentage. Coined by Benjamin Graham, it acts as a cushion against errors in assumptions. A stock with intrinsic value ₹1,000 bought at ₹700 has a 30% margin of safety.

How DCF Works — The Steps

Estimate current Free Cash Flow (FCF): FCF = Operating Cash Flow − Capital Expenditure
Project FCF growth: Estimate how rapidly FCF will grow for the next 5–10 years
Choose a discount rate (WACC): Typically 10–14% for Indian large-cap stocks
Calculate Terminal Value: The value of all cash flows beyond your projection period
Discount everything to present value
Sum all present values to get the company's intrinsic value
Apply margin of safety before deciding to buy

Example: Simplified DCF Valuation

A quality FMCG company currently generates ₹100 crore in Free Cash Flow (FCF). Assumptions:

FCF grows at 15% per year for 5 years (high growth phase)
Terminal growth rate after Year 5: 7% (steady state, near nominal GDP growth)
WACC (discount rate): 12%

Step 1 — Project FCF for Years 1–5:

Year 1: ₹100 × 1.15 = ₹115 crore → PV = ₹115 / 1.12 = ₹102.7 crore
Year 2: ₹132.25 crore → PV = ₹105.5 crore
Year 3: ₹152.09 crore → PV = ₹108.3 crore
Year 4: ₹174.90 crore → PV = ₹111.1 crore
Year 5: ₹201.14 crore → PV = ₹114.1 crore
Sum of PV of FCF (Years 1–5): ~₹541 crore

Step 2 — Calculate Terminal Value:

Terminal Value = FCF at Year 5 × (1 + Terminal Growth) / (WACC − Terminal Growth) = ₹201.14 × 1.07 / (0.12 − 0.07) = ₹215.22 / 0.05 = ₹4,304 crore

Present Value of Terminal Value = ₹4,304 / (1.12)^5 = ₹4,304 / 1.762 = ₹2,443 crore Step 3 — Total Intrinsic Value:

₹541 + ₹2,443 = ₹2,984 crore ≈ ₹3,000 crore

If the company has 10 crore shares outstanding, intrinsic value per share = ₹3,000 / 10 = ₹300 per share. With a 25% margin of safety, you'd want to buy below ₹225 per share.

DCF is extremely sensitive to assumptions

In the example above, changing the growth rate from 15% to 18% increases intrinsic value by over 40%. Changing WACC from 12% to 10% similarly inflates the value dramatically. DCF outputs are only as good as the inputs — "garbage in, garbage out." Use DCF as one input among several, not as a precise calculator of truth.

DCF vs P/E vs P/B — When to Use What

Method	Best Used For	Limitation	Indian Context
DCF	Mature companies with predictable cash flows; long-term intrinsic value	Very sensitive to growth and discount rate assumptions	Suitable for HUL, TCS, Asian Paints
P/E Ratio	Quick comparison within a sector; relative valuation	Earnings can be manipulated; distorted by one-time items	Compare Infosys P/E vs TCS P/E vs Wipro P/E
P/B Ratio	Banks and financial companies (asset-heavy)	Meaningless for asset-light businesses (IT, software)	HDFC Bank P/B = 3×, SBI P/B = 1.2×
EV/EBITDA	Capital-intensive sectors, comparing across capital structures	Requires adjusting for leases and capex	Telecom (Jio, Airtel), cement, steel

Always buy with a margin of safety

Even if your DCF analysis suggests a company's intrinsic value is ₹500, buy only at ₹350–₹400 (30% margin of safety). This protects you against being too optimistic in your projections. Graham recommended at least a 33% margin of safety; Buffett and Munger look for businesses so fundamentally excellent that even without a DCF, the margin of safety is built into the quality.

Quick Quiz

What does 'Margin of Safety' mean in the context of stock investing?

Key Takeaways

DCF estimates a company's intrinsic value by discounting future free cash flows back to present value using a discount rate (WACC).
DCF is extremely assumption-sensitive — small changes in growth rate or WACC dramatically change the output; always stress-test your assumptions.
The Margin of Safety (buy below intrinsic value by 20–30%+) protects investors from valuation errors and unforeseen business setbacks.
Use DCF alongside relative valuation (P/E, P/B) — no single method is perfect, but convergence across multiple methodologies increases confidence.

Ch 10: Technical Analysis — Introduction

Ch 12: Sectors and Cyclicals