Discounted Cash Flow (DCF) valuation is one of the most important — and most tested — topics in the NISM Series XV syllabus. It is also a core skill for any real research analyst. This guide explains DCF in plain English, with the formulas and a worked example you need for the exam.
What is DCF valuation?
DCF estimates a company's intrinsic value based on the idea that a business is worth the present value of all the cash it will generate in the future. Unlike market price, which reflects sentiment, DCF is grounded in fundamentals.
The logic in one line: money in the future is worth less than money today, so we discount future cash flows back to today.
The building blocks of a DCF
1. Free Cash Flow (FCF)
Free cash flow is the cash a business generates after covering operating expenses and capital expenditure. A common form:
FCF = EBIT × (1 − tax rate) + Depreciation − Capex − Change in Working Capital
You project FCF for an explicit forecast period — typically 5 to 10 years.
2. Discount rate (WACC)
Future cash flows are discounted using a rate that reflects risk. For firm-level valuation this is usually the Weighted Average Cost of Capital (WACC) — the blended cost of equity and debt.
3. Terminal value
You cannot forecast forever, so terminal value captures everything beyond the forecast period. The common Gordon Growth formula:
Terminal Value = FCF(final year) × (1 + g) / (r − g)
where g is the perpetual growth rate and r is the discount rate.
4. Present value
Discount each year's FCF and the terminal value to today and sum them:
Intrinsic Value = Σ [ FCF(t) / (1 + r)^t ] + [ Terminal Value / (1 + r)^n ]
A simple worked example
Suppose a company has these projected free cash flows and a discount rate (r) of 10%:
| Year | FCF (₹ cr) | Discount factor @10% | Present value (₹ cr) |
|---|---|---|---|
| 1 | 100 | 0.909 | 90.9 |
| 2 | 110 | 0.826 | 90.9 |
| 3 | 121 | 0.751 | 90.9 |
Assume a terminal growth rate g = 4%. Terminal value at end of year 3:
TV = 121 × (1.04) / (0.10 − 0.04) = 125.84 / 0.06 ≈ ₹2,097 cr
Discount the terminal value to today: 2,097 × 0.751 ≈ ₹1,575 cr. Add the present values of the three years (≈ ₹272.7 cr) to get an intrinsic value of roughly ₹1,848 cr.
If the company has 100 crore shares, intrinsic value per share ≈ ₹18.5 — compare this to the market price to judge whether the stock is undervalued or overvalued.
DCF strengths and limitations
Strengths
- Grounded in fundamentals, not market mood.
- Forces you to understand the business deeply.
Limitations
- Very sensitive to assumptions — small changes in r or g swing the value a lot.
- Hard to forecast cash flows for young or cyclical companies.
For the exam, remember that terminal value often dominates the total, and that the discount rate and growth rate are the most sensitive inputs.
What you need for the NISM XV exam
- Understand FCF, discount rate (WACC), terminal value and present value.
- Know the Gordon Growth terminal-value formula.
- Be able to interpret whether a DCF result implies a stock is undervalued or overvalued.
Practise valuation questions — DCF, P/E, P/B, EV/EBITDA and CAGR — on ScoreSetu. Every question comes with a clear explanation so the concepts stick.
Master DCF and you have conquered one of the highest-weightage areas of the NISM Series XV Research Analyst exam.