Valuation Using the Discounted Cash Flow Method

Discounted Cash Flow (DCF) Method is a valuation approach used to estimate the value of an investment, business, or asset based on its expected future cash flows. These future cash flows are projected and then discounted back to their present value using an appropriate discount rate, typically reflecting the cost of capital and risk involved.

Table of Contents

1. Introduction
2. Free Cash Flows
3. When to Apply the Discounted Cash Flow Method
4. Steps in Valuation Using Discounted Cash Flow Method
5. Free Cash Flow to the Firm (FCFF)
6. Employee Share-Based Payments (Stock Options)
7. Capital Expenditure (Capex) Including Acquisitions

Check out Taxmann's Valuation of Business Securities & Financial Assets which is a comprehensive, practice-oriented guide to valuation in today's complex economic landscape. It moves seamlessly from foundational concepts—distinguishing price from value—to advanced methods for strategic planning, compliance, litigation, and M&A scenarios. The book integrates theoretical principles with case studies, providing industry insights, analytical tools, and a global perspective enriched by in-depth coverage of Indian regulations. It equips readers with the contextual understanding and strategic acumen vital for informed, effective decision-making by covering specialised topics such as intangibles, distressed firms, and startups.

1. Introduction

The value of an asset is the present value of the cash flows associated with it, discounted at an appropriate discount rate. The Dividend Discount Model (DDM) helps in valuing a company from a minority shareholders’ perspective. For a matured company, dividends serve as a proxy for cash flows for minority shareholders. The Free Cash Flow (FCF) approach is the most preferred Discounted Cash flow method for determining the current value of a company using future cash flows adjusted for time value. Whereas dividends are the cash flows actually paid to stockholders, free cash flows are the cash flows available for distribution to shareholders. The investors and stakeholders are concerned with the amount of cash (and not book profits) that will be left behind for them. There are two forms of Free Cash Flow – Free Cash Flow to Equity (FCFE) and Free Cash Flow to Firm (FCFF).

2. Free Cash Flows

A firm receives cash through revenue or collections from customers, while it pays cash towards operating expenses, such as purchases, cost of materials, salaries, and taxes. Interest expenses are not considered operating expenses, and depreciation is excluded since they are not cash expenses. The remaining cash is used for short-term net investments in working capital, like inventory and receivables, and long-term investments in property, plant, and equipment (PP&E). The cash left over after these activities is free cash flow to the firm (FCFF), which is available to pay the firm’s debt-holders and equity shareholders. This FCFF can borrow more funds, repay existing debt, and make interest payments. After settling these obligations, the residual amount is referred to as Free Cash Flow to Equity (FCFE).

Valuers use free cash flow as the return (either FCFF or FCFE) whenever one or more of the following conditions is present –

The company does not pay dividends –

• The company pays dividend but these dividends are significantly different from the company’s capacity to pay dividends.
• Free cash flows align with profitability within a reasonable forecast period with which the valuer is comfortable.
• The valuation is done from a “control” With control comes discretion over the uses of free cash flow. If an investor can take control of the company, dividends may be changed substantially; debt could be repaid and investments can be tweaked.

Free cash flow to the firm (FCFF) is the cash flow available to the company’s suppliers of capital after all operating expenses and taxes have been paid and necessary investments in working capital (e.g., inventory) and fixed capital (e.g., fixed assets) have been made. FCFF is the cash flow from operations, less, capital expenditures. A company’s suppliers of capital include equity shareholders, lenders, bondholders, and, sometimes, preference shareholders. The FCFF equation depends on the accounting information available.

Free cash flow to equity (FCFE) is the cash flow available to the company’s equity shareholders after all operating expenses, interest, taxes, and principal payments have been paid and necessary investments in working and fixed capital have been made. FCFE is the cash flow from operations, less, capital expenditures less, payments to (plus receipts from) debtholders.

The advantage of FCFF and FCFE over other cash-flow concepts is that they can be applied directly in Discounted Cash Flow method to value the firm or to value equity. Other cash flow or earnings-related measures, such as Cash Flow form Operations (CFO) from Cash Flow Statement, Profit After Tax (PAT), EBIT, and EBITDA, cannot be applied in the same way because they either double-count or omit cash flows in some way. For example, EBIT and EBITDA are before-tax measures, and the cash flows available to investors must be after tax. From the shareholders’ perspective, EBITDA and similar measures do not account for differing capital structures (the after-tax interest expenses or preferred dividends) or for the funds that bondholders supply to finance investments in operating assets. Moreover, these measures do not account for the reinvestment of cash flows that the company makes in capital assets and working capital to maintain or maximize the long-run value of the firm.

3. When to Apply the Discounted Cash Flow Method

The free cash flow method can be applied to most types of companies regardless of their dividend policies and capital structures. However, companies that have significant capital requirements (or investments) may have negative free cash flows for years into the future. This negative free cash flow complicates the Discounted Cash Flow method and makes less reliable.

The board of directors has the authority to decide how much of the profits to distribute as dividends to shareholders and how much to retain for reinvestment. If the firm identifies significant investment opportunities that are expected to boost share prices more than paying dividends, it will keep more funds for reinvestment and distribute less as dividends. Nonetheless, because “cash is king,” shareholders value companies that provide stable dividends. Another reason the board might choose not to distribute all available funds as dividends is to ensure they can maintain consistent dividend payments even if the amount available for distribution is lower the following year by using the current year’s surplus.

The free cash flow approach highlights the perspective of a potential acquirer who seeks control over the firm and the ability to alter its dividend policy. This contrasts with the viewpoint of minority investors, who cannot influence the dividend policy and thus assess the firm based on its existing dividend practices. If an investor is willing to pay a control premium for the firm, there might be a discrepancy between the valuations derived from these two perspectives.

The Discounted Cash Flow method attempts to assess the intrinsic or fair value of a business. While valuers should ensure that the forecasted free cash flows are always realistic, the discount rate should normally assess the risk involved in the business. However, if the valuation is being done from a control perspective of the Discounted Cash Flow method, valuers often add a control premium in the discount rate, this makes the value of the company not fair from a market participant perspective. An alternative, and indeed a better approach, is to assess the fair value of the company from a market participant perspective and add a control premium to the fair value to make it aligned for a full control acquisition.

Free cash flow method is most appropriate –

• For companies that do not pay dividends or whose dividend policies are unrelated to earnings.
• Since dividends are paid at the discretion of the board of directors, it may reflect poorly on the firm’s long-run profitability.
• For companies whose free cash flow is related to their profitability
• Valuation is done from the viewpoint of controlling shareholders.

4. Steps in Valuation Using Discounted Cash Flow Method

1. Value the company’s operations by discounting free cash flow at the Weighted Average Cost of Capital (WACC).
2. Identify and value non-operating assets, such as excess cash and marketable securities, non-consolidated subsidiaries, and other assets not included in free cash Summing the value of operations and non-operating assets gives gross enterprise value.
3. Identify and value all debt and other non-equity claims against the enterprise value. Debt and other non-equity claims include fixed-rate and floating-rate debt, debt equivalents such as unfunded pension liabilities and restructuring provisions, employee options, preference shares, and others.
4. Subtract the value of debt and other non-equity claims from enterprise value to determine the value of common To estimate value per share, divide equity value by the number of current shares outstanding.

The value of equity can also be estimated directly by discounting FCFE at the required rate of return for equity (because FCFE is the cash flow going to common stockholders, the required rate of return on equity is the appropriate risk-adjusted rate for discounting FCFE).

Additional adjustments may include Cash (Add), Non-Operating Assets (Add), Assumption of external funds infused in projections (reduce).

The two free cash flow approaches for valuing equity, FCFF and FCFE, theoretically should yield the same estimates if all inputs reflect identical assumptions. A valuer may prefer to use one approach rather than the other, however, because of the characteristics of the company being valued. For example, if the company’s capital structure is relatively stable, using FCFE to value equity is more direct and simpler than using FCFF.

The FCFF model is often chosen, however, in two other cases –

• A levered company with negative In this case, working with FCFF to value the company’s equity might be easiest. The valuer would discount FCFF to find the present value of operating assets, adding the value of excess cash (“excess” in relation to operating needs) and marketable securities and of any other significant non-operating assets to get total firm value. He or she would then subtract the market value of debt to obtain an estimate of the intrinsic value of equity.
• A levered company with a changing capital structure. First, if historical data are used to forecast free cash flow growth rates, FCFF growth might reflect fundamentals more clearly than does FCFE growth, which reflects fluctuating amounts of net Second, in a forward-looking context, the required return on equity might be expected to be more sensitive to changes in financial leverage than changes in the WACC, making the use of a constant discount rate difficult to justify.
• If the company is not expected to borrow more funds, and is going to generate profits on one hand and will repay the loans on the other This will lead to higher equity in the future periods and lower Debt, leading to a changing D/E Equity Ratio.

5. Free Cash Flow to the Firm (FCFF)

Free cash flow to the firm, as described above, is used to value the firm as a whole (including shareholders and bondholders). Using the FCFF approach, the firm’s value is defined as FCFF discounted at the Weighted Average Cost of Capital (WACC).

WACC is the required return on the firm’s assets. It’s a weighted average of the required return on common equity and the after-tax required return on debt, defined as –
WACC = Wd × Kd + We × Ke
Please refer to the “Cost of Capital” section for details on WACC.

Value of the Firm = FCFF Discounted at WACC.

The FCFF discounted at WACC gives us the value of the firm’s operating assets. Although this is what matters most to investors, and non-operating assets are generally negligible, we can still find out the total value of the firm by adding non-operating assets such as land held for investment, excess cash, and marketable securities (this is not the total cash on the balance sheet). These should be found in the notes or management information.

FCFF can be obtained by either Net Income (profit after tax—PAT), EBIT, EBITDA, or Cash Flow from Operations.

5.1 Calculating FCFF from PAT

Net Profit After Tax (PAT) or Net Income available to common shareholders— usually, but not always, the bottom line in an income statement. It represents income after depreciation, amortization, interest expense, income taxes, and the payment of dividends to preferred shareholders (but not payment of dividends to common shareholders).

FCFF is calculated from PAT as follows –

FCFF = PAT + NCC + Interest (1 – t) – FCI – WCI

PAT = Profit After Tax (or Net Income)

NCC = Non-Cash Charges, E.g., Depreciation, Provisioned Expenses t = Marginal Tax Rate

FCI = Fixed Capital Investment (Net Capital Expenditure)

WCI = Working Capital Investment (Changes in Non-Cash Working Capital)

5.2 Non-cash Charges

To derive cash flow from PAT, it is necessary to make adjustments for any items that involved decreases and increases in net income but did not involve cash inflows or outflows. These items are referred to as non-cash charges (NCC). Non-cash expenses must be added back to the Profit After Tax since they lower the company’s profits even though there isn’t a cash outflow.

Non-cash charges that typically need to be added back include the following examples –

• Depreciation and amortisation – The two most prevalent non-cash charges in any business are amortization (on intangible assets) and depreciation (on tangible assets), which must be added back.
• Provisions – Expenses that show up as a write-down of profits for anticipated expenses include provisions for warranty costs and bad debts. These are liabilities that could be added back in the future.
• Restructuring expenses – Loss on sale of assets needs to be added back and Gain on sale of assets is to be subtracted.

5.3 After Tax Interest Expense and Preference Dividend

Interest expense net of the related tax savings was deducted in arriving at PAT, but interest is a cash flow available to one of the company’s capital providers (i.e., lenders). Interest expenses appear on the Profit & Loss Statement and is often paid in cash to the company’s lenders and bondholders. The after-tax interest tax is added back, nevertheless, because it serves as a financing cash flow to bondholders that the company has access to before paying any of its capital sources, the shareholders. Since paying interest lowers the tax owed, interest expense after taxes is added. For instance, the net effect of interest on free cash flow is an increase in after-tax interest cash outflow of INR 100 × (1 – 30%) = INR 70 if interest payments total INR 100 and the marginal tax rate is 30%.

Note that FCFF is discounted using after tax cost of capital (i.e., WACC considered after-tax). For consistency, FCFF is also computed by using the after-tax interest paid. It is still possible to compute WACC on a pretax basis and compute FCFF by adding back interest paid with no tax adjustment. Whichever approach is adopted, the valuer must use mutually consistent definitions of FCFF and WACC.

For the same reason as after-tax interest, Preference Dividend paid is also deducted while arriving at Free Cash Flow for the Firm. However, preference is usually not tax-deductible so no tax adjustment is required.

5.4 Deferred Taxes

Deferred taxes result from differences in the timing of reporting income and expenses in the company’s financial statements and the company’s tax return. The income tax expense deducted in arriving at net profit for financial reporting purposes is not the same as the amount of cash taxes paid. Over time, these differences between book profit and taxable profit should offset each other and have no impact on aggregate cash flows.

Generally, if the valuer’s purpose is forecasting and, therefore, identifying the persistent components of FCFF, then the valuer should not add back deferred tax changes that are expected to reverse in the near future. In some circumstances, however, a company may be able to consistently defer taxes until a much later date. If a company is growing and can indefinitely defer its tax liability, valuer should add back deferred taxes to net profit. Nevertheless, a valuer must be aware that these taxes may be payable at some time in the future.

5.4.1 Deferred Tax Asset

Companies often record expenses (e.g., restructuring charges) for financial reporting purposes that are not deductible for tax purposes or record revenues that are taxable in the current period but not yet recognized for financial reporting purposes. In these cases, taxable profits exceed financial statement profits, so cash outflows for current tax payments are greater than the taxes reported in the P&L. This results in a deferred tax asset (DTA) and a necessary adjustment to subtract that amount in deriving operating cash flow from net profit. If, however, the deferred tax asset is expected to reverse in the near future, to avoid underestimating future cash flows, the valuer should not subtract the deferred tax asset in a cash flow forecast. If the company is expected to have these charges on a continual basis, however, valuer should subtract DTA that will lower the forecast of future cash flows.

6. Employee Share Based Payments (Stock Options)

Companies record an expense for options provided to employees in the P&L. The granting and expensing of options themselves do not result in a cash outflow and are thus a non-cash charge; however, the granting of options has long-term cash flow implications. When the employee exercises the option, the company receives some cash related to the exercise price of the option at the strike price. This cash flow is considered a financing cash flow. Also, in some cases, a company receives a tax benefit from issuing options, which could increase operating cash flow but not net profit. Accounting regulations may require that a portion of the tax effect be recorded as a financing cash flow rather than an operating cash flow in the statement of cash flows. Valuers should review the statement of cash flows and footnotes to determine the impact of options on operating cash flows. If these cash flows are not expected to persist in the future, valuers should not include them in their forecasts of cash flows. Valuers should also consider the impact of stock options on the number of shares outstanding. When computing equity value, valuers may want to use the number of shares expected to be outstanding (based on the exercise of employee stock options) rather than the number currently outstanding.

7. Capital Expenditure (Capex) Including Acquisitions

As a business expands, in the long run, it would need additional fixed assets. These fixed assets may be new assets (new capex) or replacement of existing assets (replacement or maintenance capex).

Since PAT serves as the foundation for computing the FCFF, even though fixed capital investments are not shown on the Profit & Loss Statement, fixed capital investments should be deducted from PAT since they represent cash outflows for the firm –

• Investment in tangible assets to support business This may also be required to replace existing depleting assets. Note that sale of assets will reduce capital expenditure.
• Investment in intangible assets such as trademarks or These are required to gain or protect competitive advantages.
• Acquisitions of other companies to expand their operations is also a part of capex. In the case of large acquisitions (and all non-cash acquisitions), valuers must take care in evaluating the impact on future free cash For acquisition based on stock, there should be no difference than cash based acquisitions. While there may be no cash spent by a firm in the latter case, the firm is increasing the number of shares outstanding. In fact, one way to think about stock-funded acquisitions is that the firm has skipped a step in the funding process. It could have issued the stock to the public, and used the cash to make the acquisitions.

The company’s statement of cash flows is an excellent source of information on capital expenditures as well as on sales of fixed capital. Valuers should be aware that some companies acquire fixed capital without using cash—for example, through an exchange for stock or debt. Such acquisitions do not appear in a company’s statement of cash flows but, if material, must be disclosed in the footnotes. Although non-cash exchanges do not affect historical FCFF, if the capital expenditures are necessary and may be made in cash in the future, valuers should use this information in forecasting future FCFF. Alternatively, Capex can be assessed using Balance Sheet and Profit & Loss Statement.

The difference between capital expenditures, or long-term fixed asset investments, and the returns from the sale of fixed assets is known as fixed capital investment.

Capex = Purchase of Long-Term Assets – Proceeds from Sale of Long-Term Assets

Both the purchase of long-term assets and proceeds from the sale of long-term assets are generally reported on the Cash Flow Statement (Cash Flow from Investing Activities).

Without information, we can calculate fixed capital investment (or net capital expenditure) as the difference between closing and opening gross fixed assets, as the sales and purchases are incorporated in the gross fixed assets. Note that if long-term assets were sold during the year, any gain or loss on the sale is treated as a non-cash item (restructuring charges), as discussed above.

7.1 Classifying Operating Expenses as Capex

Some new age businesses derive a significant portion of their value through intangibles. These intangibles come from investment in their Research & development (R&D) or Advertisement expenses. Although accounting regulations require most of these to be expenses into P&L, valuers may treat them as capital expenditures as their benefits would likely accrue over a longer period. In such cases, P&L should be normalised to reduce these expenses (i.e., increase PAT) and treat them as capital assets. Note that if these are treated as fixed assets, depreciation would have to be charged and FCF is calculated accordingly.

There should also clearly be an impact on the estimates of capital expenditures, depreciation, and, consequently, net capital expenditures. If the valuer decided to recategorize some operating expenses as capital expenses, the current period’s value for this item should be treated as a capital expenditure. For instance, if R&D expense is capitalised, the amount spent on R&D in the current period has to be added to capital expenditures.

Adjusted Capex = Capex + R&D Expense

Since capitalizing an operating expense creates an asset, the amortization of this asset should be added to depreciation for the current period. Thus, capitalizing R&D creates a research asset, which generates an amortization in the current period.

Adjusted Depreciation & Amortisation = Depreciation & Amortisation + Amortisation on R&D Asset

The net capital expenditures of the firm will increase by the difference between the two –

Adjusted net Capex = Capex + R&D Expense for the period – Amortisation on R&D Asset

Note that the adjustment that made to net capital expenditure mirrors the adjustment made to operating income. Since net capital expenditures are subtracted from after-tax operating income, in a sense, the impact on cash flows of capitalizing R&D is nullified.

7.2 Working Capital Investment (Changes in Non-Cash Working Capital)

As a business expands, it needs to invest into working capital. For example, let’s say for generating INR 100,000 of revenue, if a company needs INR 20,000 of inventory. If the company’s revenue are expected to enhance to INR 200,000, it would need to invest into a higher amount of inventory (say INR 40,000). This higher inventory would have to be kept from setting aside a portion of existing profits. Thus, a growing business needs to invest into working capital. Similarly, if the revenues are falling, the working capital may be released and thus, investment in working capital may be negative.

Working capital is often defined as current assets minus current liabilities. However, working capital for cash flow and valuation purposes is defined to exclude cash and short-term debt (which includes short-term borrowing and the current portion of long-term debt). When finding the net change in working capital for the purpose of calculating free cash flow, working capital excludes cash and cash equivalents as well as notes payable and the current portion of long-term debt.

Cash and cash equivalents are excluded because the final objective of free Cash flow is to assess the change in free cash during the period. Also, since Discounted Cash Flow Method is assessed from a control perspective, the cash and bank balance as on the date of valuation is included back on the date of valuation. The rationale is that the acquirer will pay an amount to acquire the company but will ultimately get access to the company’s cash in terms of the Discounted Cash Flow method.

Short-term borrowing and the current portion of long-term debt are excluded because they are liabilities with explicit interest costs that make them financing items rather than operating items. Although working capital impacts the company’s cash flow, it does not affect its accounting income. The study must take the variations in working capital into account. Overestimating after-tax cash flows is the result of ignoring working capital requirements. The project’s working capital fluctuations will result in a negative present value of cash flows even if the working capital is recovered. Therefore, the project’s net present value will be inflated if working capital requirements are left out of the study. We remove cash, cash equivalents, notes payable, and the current part of long-term debt from our calculations for free cash flow.

Non-Cash Working Capital = (Inventory + Accounts Receivable) – (Accounts Payable + Taxes payable)

Further, working capital investment would be the difference between current year working capital and prior year working capital subject to adjustments above.

Example – A simple balance sheet for two years and calculate the working capital for FCFF.

* Working Capital for FCF (in this case) is Accounts Receivable + Inventory – Accounts Payable