It’s an introduction to the Discounted Cash Flow (DCF) method as a tool for estimating the intrinsic value of stocks. Here is a **free online DCF Calculator** that can be used to estimate the intrinsic value of stocks. I feel DCF is a powerful technique that goes beyond stock price. It allows us to assess a company’s true worth based on its future cash flow potential. This article will introduce you to the DCF method using the FAQs. We’ll discuss the role of the risk-free rate, the significance of the Weighted Average Cost of Capital (WACC), the importance of Free Cash Flow (FCF), and how DCF handles growth rates. We’ll also discuss the limitations of DCF.

DCF empowers you to see beyond the hype and estimate a company’s **true worth** based on its future cash flow potential. Think of it like an X-ray for stocks, revealing their **intrinsic value**

Confused by stock prices? Feeling lost in the market maze and what price to pay for a stock? You will need a reliable DCF calculator.

**Understand:** Learn the magic behind Discounted Cash Flow (DCF). It is a powerful tool to estimate a stock’s **true worth** based on its future cash flow potential. Here, I’ll try to present to you a clear understanding of DCF in the FAQs fashion.

We’ll try to cover everything from estimating future cash flows to navigating the impact of risk and growth.

**Ready to unlock the secrets of the stock market? Dive into the world of DCF**.

**P.S.** This introductory guide is just the beginning! You can further explore the advanced DCF techniques and insightful investment strategies. Read this piece on Net Present Value (NPV) estimation.

## A DCF Calculator

Data Input | ||
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Market Price | Enter the current price of the stock (Rs.) | |

Risk Free Rate (R) | Google for 10Y Govt.Bond Rate (%) | |

Expected Risk Premium (Rp) | In India Rp of 5% is sustaiable (%) | |

Stock Beta (B) | Search for stock beta in Reuters or enonomic times] | |

Total Equity (E) | Look for it in companies balance sheet in moneycontrol (Rs.Cr.) | |

Total Debt (D) | Look for it in companies balance sheet in moneycontrol (Rs.Cr.) | |

Number of Shares Outstanding (S) | Look for it in companies profit & loss sheet in moneycontrol – old format (Lakhs Nos) | |

Current Free Cash Flow (F) | To calculate free cash flow check this link: getmoneyrich.com/free-cash-flow/ (Rs.Cr.) | |

FCF Growth Rate (gf) % | This is the growth rate of current FCF for next 5 years (%) | |

Terminal Value Growth Rate (Tg) | This is the growth rate of FCF beyond the 5th year (%) |

Report | ||||||
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Chart | ||||||

Here are the top 10 FAQs related to the Discounted Cash Flow (DCF) method of intrinsic value estimation.

### 1. What is the Discounted Cash Flow (DCF) method?

The DCF method is a financial valuation technique used to estimate the **intrinsic value** of an asset like a company or its stocks. It is done by **discounting** the expected **future free cash flows** to their present value. It provides a comprehensive approach to estimating the true worth (fair value) of an investment.

Ever wondered what a stock’s **true worth** is? The **Discounted Cash Flow (DCF)** method helps you figure it out.

Think of it like this: a rupee today is worth more than a rupee tomorrow, right? DCF considers this time value of money. It estimates how much future cash a company will generate, and then **discounts** it back to today’s value. Like magic, you get the stock’s **intrinsic value**, a.k.a. its **fair price**.

**Beginners** can get a good starting point to value stocks using the DCF Method. **Experienced investors?** Use DCF alongside other analysis methods for a well-rounded picture.

### 2. What are the main variables in a DCF Calculator?

The DCF Calculator employs the following inputs to calculate the Weighted Average Cost of Capital (WACC) and ultimately calculates the intrinsic value:

- Risk-free rate,
- Expected risk premium,
- Stock beta,
- Total equity, Total debt,
- Weighted Average Cost of Capital (WACC),
- Free cash flow,
- Growth rates, and
- Present value & Discount rate.
- Terminal value.

#### Type 1 Parameters (Easier To Estimate)

**Risk-free rate (RFR) & Risk premium (RP):** Imagine a risk-free investment like government bonds, debt funds, or bank FDs. The risk premium is the extra return we expect for riskier investments like stocks. Suppose, a bank FD is giving us a return of say 6.5% per annum and we expect a return of 12% from stocks. This way, we are expecting a risk premium of 5.5% (12% – 6.5%).

**Beta (B) & Capital Structure (CS):** Beta measures how much a stock moves with the market (volatility). The company’s debt and equity ratio is called the capital structure. This ratio tells an analyst about what is the overall financing cost of the company.

RFR, RP, B, and CS are the ingredients used to calculate the **Weighted Average Cost of Capital (WACC)**. The WACC tells us the minimum return we can expect for investing in the company.

#### Type 2 Parameters (Tougher To Estimate)

**Free cash flow (FCF) & Growth (G):** Free cash flow is the money the company has left after all expenses get paid. It is different from PAT (Net Profit) because it also takes into the cost related to CAPEX and the increase in working capital. We estimate how much FCF will **grow** in the future.

**Terminal value:** As an analyst, one must estimate the capability of the company to generate FCFs in the future till it stays alive. We cannot stop our calculation at five or 10 years from today. Suppose can forecast the FCF only till the next five years. What happens to the company’s FCF after the fifth year? All free cash flow generated by the company after the fifth year is called the *terminal value*.

To know more about the concept of present value and discount rate, I suggest you visit the provided links.

**Intrinsic value!** By discounting all future cash flows and the terminal value using the WACC, we get the company’s **intrinsic value**. It is the true worth of the company based on its future earnings potential.

### 3. What role does the Risk-Free Rate play in DCF?

The Risk-Free Rate (RFR) is a crucial component in DCF calculations. It represents the return an investor would expect from a risk-free investment. It is typically based on government bond rates and is used to discount future cash flows to their present value.

Consider the risk-free Rate (RFR) in DCF is like the starting line in a race. It tells you the guaranteed return you’d get from a super-safe investment like government bonds. But stocks are riskier, like a marathon. You expect more reward for that risk, right?

DCF uses the risk-free rate (RFR) to establish a benchmark for us on how much return we can expect from a stock market. Generally speaking, the *risk premium (RP)* from stocks is say *5% per annum*.

**For example**, in the US, the risk-free rate is 4.3%, So investors in the US will expect a minimum return of 9.3% (RFR + RP) from their stocks. In India, the risk-free rate is 7%, making the minimum expected return from stocks to be 12% per annum.

### 4. What is the Significance of WACC in the DCF Formula?

WACC is calculated by considering the **cost of equity**, the **cost of debt**, and the company’s **tax rate**. These values are used to arrive at a weighted average cost of capital using the WACC formula.

A company can raise money through both **loans** (**debt**) and by selling shares (**equity**).

Each has a cost. The interest rate charged on loans is the cost of debt. The cost of equity is more complicated. Dividends and expected returns of the shareholders become the cost of equity. Read more about the total return from stocks.

The **WACC** is like the average interest rate the company pays on all its funds (debt plus equity).

Imagine a bucket with red and blue marbles. Red represents debt (cheaper) and blue represents equity (costlier). The **proportion** of each color (debt vs. equity) and their **costs** (interest vs. expected returns) are used to calculate the **average cost** or WACC.

This **WACC** is crucial in DCF. Value investors use the WACC as their **discount rate** to calculate the present value of future cash flows. A higher WACC means a higher discount, making the company’s present value **lower**.

WACC is one critical piece of the intrinsic value puzzle. Get a better understanding of WACC using examples and its application.

### 5. What is the significance of Free Cash Flow (FCF) in DCF?

Free Cash Flow (FCF) is the most critical input of the Discounted Cash Flow (DCF) Method. In any DCF Calculator, if this value is accurate, the outcome will be closest to reality. After FCF, WACC and terminal value growth rate are the next critical elements.

**Free Cash Flow (FCF)** is a cold, hard cash a company has left after paying all its bills. It even considers the expenses that are paid to maintain and grow the hard assets (like equipment or buildings). Unlike **Net Profit (PAT)**, which stops at interest and income tax payments. Moreover, FCF also adjusts itself for non-cash expenses.

FCF is used to **estimate** how much cash the company will generate in the future. It helps us figure out its true worth (intrinsic value). To get a deeper perspective of free cash flow (FCF), read this article on price to FCF ratio.

### 6. How does the DCF method handle growth rates?

The DCF Calculator incorporates growth rates in **two forms**. The first form is the growth rate of Free Cash Flow (FCF) for the next five years (let’s call it normal period growth rate). The second form is the terminal value growth rate beyond the fifth year (let’s call it the perpetual growth rate).

**Normal Period Growth Rate:**Here, we predict how much the company’s FCF will grow each year for the next**five years**. This is like, at what speed your car will drive in the first 150 kilometers of the 2,000 Km total journey. One drives faster in the first few hours, right?**Perpetual Growth Rate:**But what about after that? The car begins to drift at a perpetual growth rate which best suits the psychology of the driver. At this stage, we are assuming a long-term**growth rate**that can terminally stay active. Here we will assume a slower, simmering growth rate.

Picking the right growth rates is **very crucial**, but also tricky. What one should do here? Consider the company’s industry, past performance, and plans. Overestimation of growth can make the company look more valued than it actually is. Alternatively, a bland (underestimated) growth might miss its full potential. More care must be taken in estimating the perpetual growth rate.

Read this article on the Net Present Value calculator. It **uses the two growth rates** explained above to estimate the intrinsic value of an example company.

### 7. Can the DCF method be applied to any type of business?

The DCF method is a versatile way of estimating the intrinsic value of any company. Why? Because it values companies based on the business’s ability to generate cash flows and profits. Why a business is done? It is done to generate cash and net profit. So, DCF in a way is using these critical metrics to estimate the intrinsic value, hence it can value any type of company.

It can be used regardless of the company’s size or industry. But yes, it is indeed more useful to estimate the intrinsic value of businesses with predictable cash flows. For companies that do not make profits consistently, DCF will find it hard to value them.

Imagine valuing a startup with a revolutionary new app (exciting!) versus a stable, dividend-paying bank (reliable). Predicting the app’s future cash flow is like throwing darts in the dark. The bank, on the other hand, is more like a well-lit path.

That’s why DCF is generally **more accurate** for businesses with:

**Established track record:**Their past performance gives clues about future cash flow patterns.**Stable industry:**Less prone to sudden, unpredictable changes.

### 8. What is the relationship between Stock Beta and DCF?

Stock Beta is a measure of a stock’s **volatility** compared to the overall market. DCF calculator uses stock beta to judge how much-expected** return** is reasonable. For example, investing in a **high-beta** stock is more risky, hence as an investor, we must expect **higher returns** from such stocks. When we say higher returns, we are taking the return of the whole stock market (say **Nifty** or Sensex) as our benchmark.

Imagine a stock market roller coaster. Some stocks zoom up and down very fast (high beta). There will be others whose ascent and descent are smooth (low beta). **Beta** measures this **volatility** compared to the whole market (like Nifty or Sensex).

But what does it have to do with **DCF**?

Think of DCF as estimating a company’s future cash flow and then discounting it back to today’s value. But how much should you discount? This is where **beta** comes in.

**Higher beta = riskier stock**. So, investors expect **higher returns** for taking on that risk. DCF uses beta to adjust the **discount rate**, saying: “Hey, this stock is riskier, so we need a bigger discount to reflect that!”

Imagine two companies:

**Company A:**Steady and reliable, like a slow train (low beta).**Company B:**Zooms and dips like a thrill ride (high beta).

DCF would give **Company B a higher discount rate** due to its beta. This means its present value (estimated worth) would be **lower** compared to Company A, even if their future cash flows were similar.

### 9. How can the DCF method aid investors in decision-making?

Whenever I get confused about which stock to choose, I rely on the DCF Calculator. A more reliable tool is my Stock Engine, which is coded with a much deeper algorithm to estimate the intrinsic value of my stocks.

Here’s how a DCF Calculator can help us to make smarter decisions:

**#1 True Worth:**DCF tries to look into the future. It estimates a company’s**real value**based on its cash flow-generating capability.**#2. Quantify, Risk & Reward:**Not all stocks are created equal. DCF considers a stock’s**riskiness**(beta) and adjusts its value accordingly. This helps us weigh potential gains against potential losses.**#3. Spots Undervaluation**: DCF can help us identify stocks trading below their**true potential**. When the market price is below the DCF’s estimated intrinsic value, the stock is undervalued.**#4. Suitable For Long-term Investors**: DCF isn’t a magic formula. It values companies based on their potential to generate cash and profits (free cash flow not net profit). It uses the same logic for all types of companies. As its premise is to value companies based on their long-term potential, DCF is suitable for the buy-and-hold type of investors.

### 10. Are there limitations to the DCF method?

**DCF** is a great investment analysis tool, but like any tool, it has its limits. Here’s what to keep in mind:

**#1. Predicting the Future:**Imagine trying to guess tomorrow’s weather – tricky, right? DCF relies on estimating future cash flows, which can be as unpredictable as monsoon showers. A slight change in the company’s performance or the market can throw our estimates off.**#2. Discount Rate:**In the DCF Calculator, the**discount rate**is its magic wand. It shrinks the future cash flows to today’s value. But choosing the right rate is tricky! A small change can significantly impact the estimated worth. Analysts must be extremely careful of this sensitivity.**#3. Terminal Value Twist:**Recently I was doing the DCF analysis of a company. The present value of all future free cash flows of the company came out to be Rs.98,51,332 crores. Out of this, 78% was the contribution of this terminal value. The balance of 22% was contributed by the present value of future cash flows of the next five years from today. This excessive dependence of terminal value is one major limitation of DCF.

## Conclusion

So, do the above limitations make the **DCF method** of intrinsic value estimation **useless**? Not at all.

DCF method can still provide a valuable framework for analysis and help us understand a company’s potential. It is multiple times more effective than buying stocks without doing their DCF analysis.

To get the best output, we must remember the following:

**Use it with other methods:**Don’t rely solely on DCF. Combine it with other analyses like financial ratios or industry trends for a more complete picture.**Be aware of the limitations:**Don’t treat DCF results as absolute truth. They are estimates, so factor in the uncertainty and adjust your expectations accordingly. My**Stock Engine’s algorithm**uses multiple variations of my assumptions to establish a range of intrinsic values. Then, it takes a weighted average of all the estimated values (including other valuation models) to present a more reliable intrinsic value number.**Focus on the process:**DCF forces you to analyze fundamentals and think long-term. This process itself is valuable, even if the final number isn’t perfect. It helps us to dissect a stock and think it like a company and not just a ticker.

Have a happy investing.

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