What you need
- Intrinsic Value — The calculated "true worth" of a stock based on future cash flows, not market sentiment
- DCF = Present Value of All Future Cash Flows — Money today is worth more than money tomorrow
- Terminal Value Matters Most — Often 60-80% of total DCF value comes from terminal value
- Discount Rate = Your Required Return — Higher risk needs higher discount rate
- Margin of Safety — Only buy when market price is 30%+ below intrinsic value
- Garbage In = Garbage Out — DCF is only as good as your assumptions
What is Intrinsic Value?
Intrinsic Value Definition
Intrinsic value is the calculated "true worth" of a stock based on fundamental analysis, independent of its current market price. It represents the present value of all future cash flows a company is expected to generate for shareholders. If intrinsic value exceeds market price, the stock is considered undervalued — a potential buy.
Here's the key insight: The market price is what others are willing to pay. Intrinsic value is what the business is actually worth.
Imagine you're buying a rental property. You wouldn't pay based on what your neighbor thinks it's worth. You'd calculate based on the rent it generates, expenses, and what similar properties sell for. Stocks work the same way.
Market Price
What the market is willing to pay right now. Driven by sentiment, news, fear, greed. Changes every second. Often irrational.
Intrinsic Value
The calculated true worth based on fundamentals. Driven by cash flows, growth, profitability. Changes slowly. More rational.
The Gap = Opportunity
When market price is significantly below intrinsic value, you have a buying opportunity. When above, time to sell or avoid.
"Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses."
— Warren Buffett, Berkshire Hathaway Annual Letter
Contrarian Take
Everyone's worried about Meta's metaverse spending. They should be. But what they miss is that Meta's AI advertising engine is so far ahead, they can burn $10B yearly on moonshots and still dominate.
DCF Analysis Explained Simply
DCF (Discounted Cash Flow) is the gold standard for intrinsic value calculation. The core principle is simple: A business is worth the sum of all cash it will generate in the future, discounted to today's value.
Because you could invest ₹100 today and earn returns. This is the "Time Value of Money"
The DCF Logic in Plain English
- Step 1: Estimate how much free cash the company will generate each year for the next 5-10 years
- Step 2: Estimate what happens after that (terminal value) — assuming the company continues forever
- Step 3: Discount all those future cash flows to today's value (because future money is worth less)
- Step 4: Add up all the present values = Total intrinsic value of the business
- Step 5: Divide by shares outstanding = Intrinsic value per share
Step-by-Step DCF Calculation
Let's break down each step of the DCF analysis process:
Calculate Free Cash Flow (FCF)
Free Cash Flow is the cash generated by operations after paying for capital expenditures. It's the real cash available to shareholders.
Project Future FCF (5-10 Years)
Estimate FCF growth for the next 5-10 years based on historical growth, industry outlook, and competitive position. Be conservative — optimistic projections lead to overvaluation.
Determine the Discount Rate
Use WACC (Weighted Average Cost of Capital) or a simple required return rate. Higher risk = higher discount rate. For most stable companies, use 10-12%.
Calculate Terminal Value
Terminal value captures all cash flows beyond your projection period. It often represents 60-80% of total value, so be careful with assumptions.
Discount All Cash Flows to Present Value
Convert each year's cash flow to today's value using the discount formula. The further in the future, the lower the present value.
Sum Up and Calculate Per-Share Value
Add all present values together, subtract net debt (debt minus cash), and divide by shares outstanding to get intrinsic value per share.
Real Company DCF Example
Given: Current Free Cash Flow = ₹1,000 Cr | Expected Growth = 15% (Years 1-5) then 8% (Years 6-10) | Terminal Growth = 3% | Discount Rate = 12% | Net Debt = ₹2,000 Cr | Shares = 100 Cr
| Year | FCF (₹ Cr) | Growth | Discount Factor | Present Value (₹ Cr) |
|---|---|---|---|---|
| 1 | 1,150 | 15% | 0.893 | 1,027 |
| 2 | 1,323 | 15% | 0.797 | 1,054 |
| 3 | 1,521 | 15% | 0.712 | 1,083 |
| 4 | 1,749 | 15% | 0.636 | 1,112 |
| 5 | 2,012 | 15% | 0.567 | 1,141 |
| 6-10 | 2,173 → 2,956 | 8% | Various | 3,890 |
| Terminal | 33,814 | 3% forever | 0.322 | 10,888 |
| Total Enterprise Value | ₹20,195 Cr | |||
| Less: Net Debt | - ₹2,000 Cr | |||
| Equity Value | ₹18,195 Cr | |||
| Intrinsic Value Per Share (÷ 100 Cr shares) | ₹182 | |||
Interpretation: If the current market price is ₹130, the stock is trading at a 28% discount to intrinsic value — potentially undervalued. If it's trading at ₹250, it's 37% overvalued.
Free DCF Calculator Tool
DCF Intrinsic Value Calculator
Calculate the fair value of any stock using Discounted Cash Flow analysis
*Calculator is for educational purposes only. DCF results are highly sensitive to assumptions.
Margin of Safety Concept
The Margin of Safety is the most important concept in value investing. It's the difference between intrinsic value and the price you pay.
"The margin of safety is always dependent on the price paid. It will be large at one price, small at some higher price, nonexistent at some still higher price."
— Benjamin Graham, The Intelligent Investor
Why Margin of Safety Matters
- Protects Against Errors: Your intrinsic value calculation will likely be wrong. A margin of safety provides a buffer.
- Covers Unknown Risks: Future events can hurt the business. The margin absorbs unforeseen problems.
- Improves Returns: Buying below intrinsic value mathematically increases your expected returns.
- Reduces Stress: When you pay significantly less than value, temporary price drops matter less.
The 30% Rule
Professional value investors typically require at least a 30% margin of safety before buying. If intrinsic value is ₹200, they wait until price drops to ₹140 or below. The more uncertain the valuation, the larger the margin required.
Other Valuation Methods
DCF is powerful but not the only way to value stocks. Smart investors triangulate using multiple methods:
DCF (Discounted Cash Flow)
Absolute valuation based on projected future cash flows discounted to present value.
Relative Valuation (P/E, EV/EBITDA)
Compare valuation multiples to similar companies or historical averages.
Asset-Based Valuation
Value based on net asset value — what company owns minus what it owes.
Pro Tip: Use multiple methods and see if they converge. If DCF says ₹200, P/E comparison says ₹180, and asset value says ₹150, you have a range of ₹150-200. Buy only when market price is well below this range.
DCF Limitations & Pitfalls
DCF is powerful but far from perfect. Understanding its limitations makes you a better analyst.
Garbage In, Garbage Out
Small changes in growth rate or discount rate dramatically change output. A 12% growth vs 15% growth can mean 40%+ difference in value. Your assumptions drive everything.
Terminal Value Dominance
60-80% of DCF value often comes from terminal value — the most uncertain part. You're essentially guessing growth rates into infinity.
Hard to Predict Companies
DCF works best for stable, predictable businesses. For cyclical companies, startups, or rapidly changing industries, projecting cash flows is unreliable.
False Precision
DCF gives you a precise number like ₹187.43, but that precision is illusory. The real answer is "somewhere between ₹150 and ₹220."
Warren Buffett's Approach
"I would rather be approximately right than precisely wrong." Buffett focuses on businesses where future cash flows are reasonably predictable. He doesn't try to value tech startups or commodity businesses — too unpredictable. Focus your DCF efforts on stable, understandable businesses.
FAQs
For Indian stocks, use higher discount rates due to higher interest rates and risk premiums. Large-cap stable companies: 11-13%. Mid-caps with good track record: 13-15%. Small-caps or riskier companies: 15-18%. You can also use 10-year government bond yield (currently ~7%) plus an equity risk premium of 5-8%.
From the Cash Flow Statement: FCF = Cash Flow from Operations (CFO) minus Capital Expenditures (CapEx). Alternatively: FCF = Net Income + Depreciation & Amortization - Changes in Working Capital - CapEx. For most analyses, the first method using the cash flow statement is simpler and more reliable.
Standard practice is 5-10 years. For high-growth companies, use 10 years to capture the growth phase. For mature, stable companies, 5 years is sufficient. Beyond 10 years, projections become too unreliable. Remember: the more years you project, the more sensitive your model becomes to assumptions.
Technically yes, but it's very difficult and unreliable. For companies investing heavily for growth (negative FCF now), you're essentially guessing when and how much positive FCF they'll generate. For such companies, consider Price/Sales, EV/Revenue, or optionality-based valuation. DCF works best for profitable, cash-generating businesses.
Buffett only invests in businesses he understands deeply with highly predictable cash flows. For such "certain" businesses, he argues using a low discount rate is appropriate. However, he compensates by requiring a large margin of safety (buying at a big discount to intrinsic value). Most investors should use WACC or required return rates since we can't match Buffett's conviction in predictions.