DCF Modelling

Reference Notes
STUDENT REFERENCE EDITION

Valuation logic, FCFF vs FCFE, WACC, cost of equity, beta (regression & bottom-up),
DOL/DFL, terminal value and a full source-audit checklist.

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Contents

1. What is Valuation?
2. Types of Valuation
3. FCFF vs FCFE
4. Flow of Steps for a DCF
5. Visual Aid — Explicit Forecast + Terminal Value
6. Forecasting Revenue
7. Forecasting the Financial Statements
8. Terminal Value — Exit Multiple Method
9. WACC
10. Cost of Debt
11. Cost of Equity, ERP and Country Risk Premium
12. Beta — Regression vs Bottom-up
13. Regression Beta in Excel
14. Bottom-up Beta — Lever, Unlever, Relever
15. Asset Beta, DOL and DFL
16. DOL and DFL — Formulas
17. Bottom-up Beta — Step by Step
18. Source Register — Where Every Number Comes From
19. Practical Source Links
20. Final Student Checklist

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1 What is Valuation?
Valuation is the process of estimating the economic worth of an asset, business or equity share. It is not a formula
exercise — it is a structured argument about future cash flows, risk, growth and required return.

A good valuation answers three questions:

• How much cash can the business generate?

• How risky are those cash flows?

• How much should an investor pay today for those future cash flows?

Key distinction
• Value is not the same as price. Price is what the market quotes today; value is what the business is worth based
on your assumptions.
• Every valuation is assumption-driven. A transparent valuation shows the source and logic behind every important
number.

2. Different Types of Valuation

INTRINSIC VALUATION / DCF TRANSACTION / PRECEDENT

RELATIVE VALUATION
DEALS
→ →
Value = present value of future cash
Value = multiple × financial metric (P/E,
flows. Forecast-driven, uses terminal Value from M&A; multiples. Reflects
EV/EBITDA, P/B). Fast, market-based.
value. control premium and deal appetite.

Classroom shorthand
Relative valuation asks “what are similar companies trading at?” DCF asks “what should this company be worth
based on its own future cash flows?” Transaction valuation asks “what did buyers actually pay in real deals?”

Relative valuation is quick but depends on how genuinely comparable the peer set is. Intrinsic valuation is slower but
more fundamental, since it values the company on its own cash flows. Transaction valuation is useful for M&A;
analysis, but the multiples paid often include synergy value and a control premium that don't belong in a standalone
valuation.

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3 FCFF vs FCFE: Why Both Exist

FCFF — Free Cash Flow to Firm FCFE — Free Cash Flow to Equity

Cash flow available to all capital providers (debt + Cash flow available only to equity shareholders.
equity).
Formula:
Formula: PAT + D&A − Capex − Increase in NWC + Net Debt
EBIT × (1 − tax rate) + D&A − Capex − Increase in Raised
NWC
Discount rate: Cost of Equity
Discount rate: WACC Result: Equity Value
Result: Enterprise Value

• Both should give the same equity value if assumptions are internally consistent.
• FCFF values the whole business first and then subtracts net debt. FCFE values equity directly.
• FCFF is preferred in practice when leverage changes over time or debt policy is unstable.

The key discipline is matching the cash flow to the correct discount rate: FCFF is a pre-debt cash flow, so it must be
discounted at WACC. FCFE is a post-debt cash flow, so it must be discounted at cost of equity.

Equity value from the FCFF route = Enterprise Value − Debt − Minority Interest + Cash + Non-operating Assets.
Equity value from the FCFE route is obtained directly by discounting FCFE at cost of equity.

4. Flow of Steps for a DCF

1 · FORECAST 2 · FORECAST IS / BS
3 · CALCULATE FCFF 4 · TERMINAL VALUE
REVENUE / CFS
Top-down or bottom-up → EBIT, tax, D&A;, capex, → Operating cash flow after → Exit multiple or perpetuity
reinvestment growth
drivers NWC

6 · ENTERPRISE 8 · VALUE PER

5 · DISCOUNT CASH 7 · EQUITY VALUE
VALUE SHARE
FLOWS
→ PV of explicit FCFF + PV of → EV − debt − MI + cash + → Equity value ÷ diluted
Use WACC for FCFF non-op assets
TV shares

Model discipline
Every assumption should connect to a source, a driver, or an operating logic. Avoid unexplained hard-coded
numbers.

The process starts with operations and ends with value per share. Forecast revenue, margins, taxes, reinvestment
and working capital first — only then calculate FCFF, terminal value and present value.

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5 Visual Aid — Explicit Forecast + Terminal Value

This is the single most important mental picture in DCF: forecast a limited period explicitly (usually 5–10 years), then
assume the business continues beyond that point through a terminal value. Both the explicit FCFFs and the terminal
value get discounted back to today at WACC.

Today FCFF1 FCFF2 FCFF3 FCFF4 FCFF5 Terminal

Apr 2026 FY1 2027 FY2 2028 FY3 2029 FY4 2030 FY5 2031 Beyond FY5

Terminal Value at FY5 = FY6 EBITDA × Exit Multiple OR FCFF6 / (WACC − g)

Equity Value
Enterprise Value Today
= Enterprise Value − Debt
= PV of FCFF1 to FCFF5
+ PV of Terminal Value
→ − Minority Interest + Cash
+ Non-operating Assets

Terminal value is usually the largest single component of enterprise value — often 60–80% of it. That is exactly why
the terminal multiple, terminal growth rate and WACC assumptions deserve more scrutiny than any single year of the
explicit forecast.

6. Forecasting Revenue

BOTTOM-UP
TOP-DOWN
→
Operational drivers: stores × sales/store, beds × occupancy ×
Industry size × company market share × pricing/mix. Useful
ARPOB, users × ARPU. Useful when unit economics explain
when the business tracks overall market penetration.
the business.

Common mistake to avoid

Don't project consolidated revenue as one flat growth number if the company has multiple segments. Forecast
each segment separately using its own drivers, then consolidate — this is both more accurate and easier to
defend.

Revenue forecasting starts with understanding the business model. A mature FMCG company is typically forecast
on volume, price and mix. A hospital chain needs beds, occupancy, ARPOB, outpatient revenue and
pharmacy/diagnostic revenue. A software company needs customers, retention, pricing and ARPU.

Always finish with a reasonableness check: compare implied growth against historical growth, management
guidance and industry growth.

7. Forecasting the Income Statement, Balance Sheet and Cash Flow Statement
After revenue, forecast the major operating lines. For DCF purposes the outputs that matter are EBIT, tax,
depreciation and amortisation, capex and net working capital — these feed directly into FCFF.

FCFF = EBIT × (1 − tax rate) + D&A − Capex − Increase in Net Working Capital

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• D&A is added back because it is a non-cash charge.

• Capex is deducted because it is a real cash outflow needed to maintain and grow the business.

• The increase in working capital is deducted because cash gets tied up in receivables and inventory, net of
payables.

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8 Terminal Value — Exit Multiple Method

STEP 1 — FORECAST FY5 & FY6 EBITDA STEP 2 — SELECT EXIT MULTIPLE
FY5 is the last explicit forecast year; FY6 is the first year beyond → Use comparable-company or transaction EV/EBITDA multiples.
it. Choose a sustainable, normalized multiple.

Terminal Value at FY5 = FY6 EBITDA × Exit EV/EBITDA multiple

Worked example
If FY6 EBITDA = ■200 cr and the exit multiple is 10×, Terminal Value at FY5 = ■2,000 cr.

Important
This terminal value sits at the end of FY5 — it is not today's value. It must be discounted back to the valuation date
using WACC, same as every other explicit-period cash flow.

• Use forward-looking EBITDA if the market multiple you're applying is itself a forward multiple.

• Use normalized EBITDA — not a one-off cyclical high or low.

• Cross-check the exit multiple against current peer multiples, the historical trading range, and industry maturity.

9. WACC — Weighted Average Cost of Capital

WACC = w × k × (1 − tax rate) + w × k

D D E E

w_D Tax shield w_E

k_D k_E
Market value weight of Interest is tax Market value weight of
debt Pre-tax cost of debt deductible equity Cost of equity

Use WACC only for FCFF — FCFF is a cash flow before debt servicing, and belongs to both lenders and
shareholders.

WACC is the blended opportunity cost across all capital providers. Weights should ideally use market values, not
book values. The tax adjustment applies only to the cost of debt, because interest is tax deductible — there is no
equivalent shield on the cost of equity.

10. Cost of Debt

BOOK INTEREST METHOD RATING / SPREAD METHOD

Pre-tax k_D = Interest Expense / Average Debt. Useful when → Pre-tax k_D = Risk-free rate + Credit spread, based on actual or
market data isn't available, but reflects historical borrowing cost. synthetic rating.

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After-tax cost of debt = Pre-tax cost of debt × (1 − marginal tax rate)

Cost of debt is the current borrowing cost for the company, not necessarily the historical coupon on old debt — the
goal is to estimate what lenders would demand today. For forward-looking DCF work, the rating/spread method is
conceptually stronger than the book-interest method, and always use the marginal tax rate since it reflects the future
tax shield on interest.

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11 Cost of Equity, ERP and Country Risk Premium

Cost of Equity = Risk-free Rate + Beta × Equity Risk Premium (ERP)

RISK-FREE RATE BETA ERP

Usually the 10-year government bond → Sensitivity of the stock/business to → Extra return investors demand over the
yield in the valuation currency. market risk. risk-free rate for holding equities.

What is ERP? Equity is risky — profits can fall, prices can crash, management can misallocate capital, competition
can intensify. So investors demand a return above the safe government-bond rate. That extra demanded return is
the Equity Risk Premium. For a consistent public dataset, use Prof. Aswath Damodaran's NYU Stern tables, and
record the date you pulled the data — ERP is updated periodically.

Worked example
Risk-free rate = 7% · Beta = 1.2 · ERP = 6%
Cost of Equity = 7% + (1.2 × 6%) = 14.2% — the return equity investors would demand from this stock.

The logic: start with the safe return, then add extra return for market risk. A beta above 1 means the company is
riskier than the market, so the ERP impact is amplified. A beta below 1 dampens it.

Country Risk Premium (CRP) — the extra return investors demand for investing in a market riskier than a stable
developed benchmark like the US. A common approach for emerging markets:

ERP (India) = ERP (US) + CRP (India)

Worked example
US ERP = 4.5% + India CRP = 2.5% = ERP (India) = 7.0%

CRP captures risks that are specific to the country rather than the company:

Risk What it captures

Political risk Policy changes, elections, regulatory uncertainty

Currency risk Local currency depreciation affecting foreign investors

Inflation risk Higher or unstable inflation

Sovereign risk Government borrowing/repayment risk

Liquidity risk Market depth typically lower than developed markets

Institutional risk Legal, accounting, governance and enforcement risk

Two identical businesses — one in the US, one in India — can still command different required returns purely
because of these country-level factors. That gap is CRP.

Why the risk-free rate alone isn't enough: it only captures the time value of money on a safe asset. It says nothing
about the possibility that a stock falls 30–50%, a company loses market share, or debt becomes a problem. Using

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the risk-free rate alone as a discount rate would imply equity is as safe as a government bond — which is clearly
wrong.

Component What it captures What it doesn't capture

Risk-free rate Time value of money, safe return Equity market risk

ERP Extra risk of investing in stocks generally Company-specific risk, country risk

Beta How much of that market risk this stock carries Country risk by itself

CRP Additional country-level risk Individual company risk

One-line summary
For an Indian company: Cost of Equity = Risk-free Rate + Beta × (US ERP + India CRP). Each term isolates a
different layer of risk — time value, market risk, and country risk.

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12 Beta: Regression vs Bottom-up

REGRESSION BETA BOTTOM-UP BETA

→
Run a regression of stock returns against market index returns. Start with comparable listed companies, unlever their betas to
Beta = slope of the line. Good when the stock is liquid with strip out capital structure, average, then relever to your target
reliable trading history. capital structure.

When to use which

Use regression beta for a mature listed company with enough trading history. Use bottom-up beta for unlisted
companies, newly listed companies, thinly traded stocks, or when the target has a different debt-to-equity mix than
its own history.

Beta measures sensitivity to market risk, not total risk. A beta of 1.2 means the stock tends to move more than the
market; 0.7 means it tends to move less. It captures only systematic (market-wide) risk, not company-specific risk.

13. Regression Beta in Excel

1 · DOWNLOAD 2 · CONVERT 3 · PLOT 4 · ADD

5 · READ BETA
PRICES TO RETURNS SCATTER TRENDLINE
Stock & benchmark → Return = Price_t / → X = market return, Y → Display equation on → Slope of trendline =
beta
adjusted close Price_t-1 − 1 = stock return chart

Beta = SLOPE(stock returns, market returns) = COV(x,y) / VAR(x)

• Use adjusted prices — dividends, bonuses and splits distort raw prices.

• Match frequency between stock and index: daily with daily, weekly with weekly.

• For valuation work, weekly returns over 3–5 years is a common practical compromise.

14. Bottom-up Beta — Lever, Unlever, Relever

LISTED COMPARABLES UNLEVER BETA RELEVER BETA

Observed equity beta already includes → Asset beta = Equity beta / [1 + (1 − tax) → Equity beta = Asset beta × [1 + (1 − tax)
each comparable's own leverage. × D/E] × D/E] using target capital structure.

This method separates business risk from financing risk. The unlevered (asset) beta is the risk of the operating
business before any debt. The relevered beta is the risk to equity holders once you apply the target debt-equity
structure — which may differ from any single comparable's actual structure.

15. Asset Beta, DOL and DFL

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DFL
DOL
ASSET BETA Degree of Financial Leverage —
→ →
Degree of Operating Leverage — first
Pure business risk, before any second magnifier. Debt makes EPS
magnifier. Fixed operating costs make
operating or financial leverage effects. and equity returns more sensitive to
EBIT more sensitive to sales.
EBIT.

Equity Beta ≈ Asset Beta × DOL × DFL

Asset beta is the pure business risk. DOL amplifies operating risk because fixed operating costs make EBIT more
volatile than sales. DFL amplifies financial risk because fixed interest cost makes EPS more volatile than EBIT. In
formal models the standard relevering formula (Section 14) captures financial leverage directly — this framework is a
useful mental model for why fixed operating costs and debt both raise equity risk.

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16 DOL and DFL — Formulas and Meaning

DOL DFL

DOL = % change in EBIT / % change in Sales DFL = % change in EPS / % change in EBIT

High fixed operating costs mean EBIT moves more High debt and fixed interest cost mean EPS moves
than sales. Airlines, hotels and manufacturing tend to more than EBIT. More debt generally raises DFL.
run higher DOL.

DOL magnifies operating risk. DFL magnifies financial risk. Together they explain why two firms in the same
industry can carry very different equity betas.

A company with both high fixed operating costs and high debt can carry very high equity risk even when the
underlying product demand looks stable.

17. Bottom-up Beta — Step by Step

1 Select comparable listed companies from the same or a similar business model.

2 Collect each comparable's regression beta or published beta.

3 Collect market value of equity, debt, cash and tax rate for each.

4 Unlever each beta: Asset beta = Equity beta / [1 + (1 − tax rate) × D/E].

5 Average the asset betas — use the median too as a robustness check.

6 Relever the average asset beta using the target company's target capital structure.

7 Use the relevered beta in CAPM to estimate cost of equity.

Worked context
For an unlisted exchange like the NSE, a listed peer such as BSE can be one reference point for beta — but it
shouldn't be the only comparable if other global exchanges are relevant. Use a single peer as a simple teaching
example, then expand the peer set for real professional work.

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18 Source Register — Where Every Number Comes

From
Keep this register at the end of every model. It stops unexplained hard-coded assumptions and makes the whole
model auditable.

Input Used in Recommended source Notes

Valuation date All market-linked Model assumption / class date All market values must match this date.
inputs

Stock price Market cap, beta, [Link], NSE/BSE historical data, Use adjusted prices for return
peer multiples Bloomberg/Capital IQ calculations.

Shares Equity value per Latest annual report / quarterly filing Use diluted shares if options or
outstanding share convertibles are material.

Risk-free rate Cost of equity, 10-yr govt bond yield in valuation Currency must match the cash flows —
WACC, cost of debt currency (India: RBI, FIMMDA) INR cash flows need an INR risk-free
rate.

Equity Risk Cost of equity Prof. Damodaran's NYU Stern data / Use one consistent ERP methodology
Premium implied ERP tables throughout the model.

Country Risk Cost of equity or ERP Prof. Damodaran's country risk premium Base it on revenue/geographic
Premium adjustment table exposure, not just country of
incorporation.

Beta Cost of equity Regression from stock/index returns, or Document whether it's regression or
bottom-up from comparables bottom-up beta, and the peer list.

Tax rate NOPAT, after-tax Annual report tax note, statutory rate Use a normalized marginal rate for
cost of debt forward valuation.

Debt EV-to-equity bridge, Balance sheet, notes to accounts Use market value of debt if materially
WACC weights different and available.

Cash & EV-to-equity bridge Balance sheet and notes Separate operating cash from
investments excess/non-operating cash.

Minority interest EV-to-equity bridge Consolidated balance sheet Subtract MI — EV includes all
consolidated operations.

Revenue drivers Revenue forecast Filings, investor presentations, industry Segment-level assumptions beat one
reports blended growth rate.

EBITDA/EBIT Operating forecast, Historicals, peer margins, management Tie margins to scale, pricing, cost
margin terminal value guidance structure and competition.

Capex FCFF Cash flow statement, capex guidance Check capex as % of sales and against
depreciation.

Net working FCFF Receivables, inventory, payables on Don't include cash or debt in operating
capital balance sheet working capital.

Exit EV/EBITDA Terminal value Comparable trading or transaction Match a forward multiple with forward
multiple multiples EBITDA — don't mix periods.

Index returns Regression beta Relevant benchmark index (e.g., NIFTY The index should match the investor's
50, Sensex) actual opportunity set.

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19 Practical Source Links

Source Location Use

Prof. Damodaran — current [Link]/~adamodar/New_Home_ ERP, country risk premium, industry data and
data Page/[Link] valuation datasets.

Prof. Damodaran — country [Link]/~adamodar/New_Home_ Country risk premium and default spread
risk premiums Page/datafile/[Link] reference.

[Link] [Link] Stock and index historical price data

(daily/weekly/monthly).

NSE historical reports [Link]/resources/historical-reports-capit Indian equity price-volume history, bhavcopy,

al-market-daily-monthly-archives index data.

BSE corporate filings [Link] Company filings, announcements,

shareholding pattern, market data.

CCIL / RBI data [Link] Government securities and macro/interest-rate

data for INR risk-free rate cross-checks.

Company annual reports Company website, NSE, BSE Financial statements, debt, cash, shares, tax,
segment revenue, MD&A.;

Record the exact data point, date and download time alongside each figure you pull from these sources — that's
what makes the model auditable later.

20. Final Student Checklist

✓ Every forecast number has either a formula, a driver, or a source note.

✓ Every market number has a date attached to it.

✓ Cash flow type matches the discount rate: FCFF with WACC, FCFE with cost of equity.

✓ Terminal value is discounted back to the valuation date, not left at the end of the forecast period.

✓ Enterprise value is properly bridged to equity value before calculating value per share.

✓ Sensitivity analysis is run on WACC, terminal growth/exit multiple, and revenue or margin assumptions.

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