Discounted cash flow

Chapter 16 said a business is worth its future cash discounted. A discounted cash flow model is that sentence written out.

The structure

Four steps.

1. Forecast free cash flow for an explicit period, usually five to ten years. Chapter 6's definition: cash from operations less capital expenditure. For a whole-business valuation, use the version before interest, since the debt is handled separately.

2. Pick a discount rate — the weighted average cost of capital, below.

3. Compute a terminal value for everything after the forecast period, usually by assuming constant growth for ever:

terminal value = final year cash flow × (1 + g) ÷ (r − g)

4. Discount everything back to today and add it up. That is enterprise value; subtract net debt for the equity value, and divide by shares for a per-share figure.

The discount rate

The weighted average cost of capital blends what the company pays for debt and what shareholders require, weighted by how much of each funds the business.

Debt is the easier half: the interest rate, reduced for the tax deduction on interest.

The cost of equity is a judgement. The usual construction is a risk-free rate — chapter 2 of the fixed income subject's government security — plus a premium for equity risk, adjusted for how volatile this particular share is relative to the market.

Be honest about what that is. It is a reasoned estimate with a wide range, and chapter 16 showed two percentage points moving value 25%. Anyone presenting a WACC to two decimal places is presenting precision that does not exist.

The terminal value problem

The thing most people discover only after building one.

For most businesses, more than half the total value sits in the terminal value — often two-thirds or more.

Which means the careful ten-year forecast, the segment assumptions, the margin path, all of it, determines a minority of the answer. The majority comes from one formula with two inputs: a perpetual growth rate and a discount rate, applied to a cash flow a decade out.

Two consequences follow.

Small changes in the terminal assumptions dominate. Growth of 4% instead of 3% can move the valuation 15% or more. That is not a modelling error; it is what the arithmetic does.

The perpetual growth rate must be modest. Chapter 16: a business growing faster than the economy for ever eventually becomes the economy. A terminal growth rate above long-run nominal economic growth is an assumption that cannot hold, and it is the most common way a DCF produces a flattering number.

A useful discipline is to express the terminal value as an implied exit multiple — divide it by the final year's earnings — and ask whether that multiple is plausible for a mature business in this industry. If the implied exit multiple is 30 times, the model is assuming something it should state out loud.

Where DCFs go wrong

Garbage in. The model is arithmetic. Optimistic inputs produce an optimistic answer with the authority of a spreadsheet, and the spreadsheet adds nothing but confidence.

False precision. A model output of ₹1,247 per share invites belief. Build three scenarios instead and look at the range.

Reverse-engineering. The commonest failure in practice: the analyst knows the answer wanted and adjusts the growth rate until the model produces it. The output then looks like analysis and is a restatement of the prior.

Forecasting the unforecastable. Nobody knows a company's cash flow in year eight. That is not a reason to skip the exercise, and it is a reason to hold the output loosely.

What it is genuinely good for

Despite all of that, three real benefits.

It forces the assumptions into the open. Chapter 17's P/E hides growth, risk and cash conversion inside one number. A DCF makes you write them down, where they can be argued with.

It shows what drives value. Change one input at a time and you learn which assumptions matter. Usually it is a small number of them, and knowing which to monitor is worth more than the valuation.

It disciplines a story. "This company will dominate its market" becomes a revenue number and a margin, and sometimes the implied figures turn out to be absurd when written down.

The honest summary

A DCF is a machine for converting assumptions into a number. Its value is in the assumptions, not the number — and if that sounds like a reason to skip the machine, chapter 21 is the version that keeps the insight and drops the forecasting.

The point

A DCF forecasts free cash flow, discounts it at the cost of capital, and adds a terminal value that usually accounts for most of the answer — so the method rests heavily on two inputs about a distant future. Its real worth is forcing assumptions into the open and showing which ones matter, not the precise figure it produces.