Discounted cash flow

Valuing a business as the present value of the cash it will produce for its owners over its life. The idea is uncontroversial and the execution is where all the difficulty sits.

The mechanics are three steps. Forecast free cash flow for an explicit period, usually five to ten years. Estimate a terminal value for everything after that. Discount both back at the cost of capital and add them up.

Three years of ₹325 crore, ₹350 crore and ₹375 crore discounted at 11.5% are worth ₹844 crore today, and the terminal value would sit on top.

What people miss is where the value comes from. In a typical model built over ten years, 60% to 80% of the answer is in the terminal value, which means the majority of the number rests on a growth rate and a discount rate applied to a year nobody can forecast. The explicit forecast is where the work goes and the terminal assumption is where the answer is.

Build it to understand the business, not to produce a target price.

Three steps. All the difficulty is in the second.

The most useful discipline in building one is to write down, before touching a spreadsheet, what the business has to do for the model to be right. Revenue at some rate, margins at some level, capital spending at some ratio, and returns holding for some number of years. Those four sentences are the investment case, and the spreadsheet only converts them into a number. Analysts who start from the spreadsheet end up adjusting assumptions until the answer feels comfortable, which is a well-documented failure and produces a valuation that says more about the analyst than the company.