Fundamental Analysis
Case Study: Valuing a Company Using DCF (Real Example)
By Worldtickers ·
A step-by-step case study of valuing a real company using DCF — projecting cash flows, calculating WACC, determining terminal value, and arriving at intrinsic value.
Company Selection & Overview
For this case study, we will value a fictional Indian manufacturing company, Precision Engineering Ltd, using the Discounted Cash Flow (DCF) method. Precision Engineering manufactures industrial components for the automotive and aerospace sectors in India. The company has been publicly listed for 12 years, has a consistent track record of profitability, and generates predictable cash flows, making it an ideal candidate for DCF valuation.
Precision Engineering has revenue of Rs 1,200 crore, EBITDA of Rs 240 crore (20% margin), net income of Rs 144 crore, and free cash flow of Rs 96 crore. The company has net debt of Rs 200 crore and 5 crore outstanding shares trading at Rs 480 per share, giving it a market capitalization of Rs 2,400 crore and an enterprise value of Rs 2,600 crore. The stock currently trades at a PE ratio of 16.7x and an EV/EBITDA of 10.8x.
Our objective is to determine whether Precision Engineering is fairly valued at its current market price by building a DCF model. We will project the company's free cash flows for the next five years, calculate an appropriate discount rate, determine the terminal value, and arrive at an intrinsic value per share. We will then compare this intrinsic value with the current market price to make an investment recommendation. Before diving in, review the fundamentals of DCF in What Is DCF (Discounted Cash Flow) Valuation? Step-by-Step Guide.
Historical Financial Analysis
The first step in any DCF valuation is to understand the company's historical financial performance as a basis for projections. Precision Engineering has grown revenue at a CAGR of 12% over the past five years, from Rs 680 crore to Rs 1,200 crore. EBITDA margins have been stable at 19-20%, indicating consistent operating performance. The company has maintained capital expenditure at approximately 5% of revenue, slightly above depreciation, suggesting moderate reinvestment needs.
Working capital management has been efficient, with Days Sales Outstanding (DSO) averaging 45 days, Days Payable Outstanding (DPO) at 35 days, and Days Inventory Outstanding (DIO) at 60 days. The cash conversion cycle has remained stable at approximately 70 days. Free cash flow conversion has been strong, with FCF averaging 70-75% of EBITDA over the past five years. The company has maintained a conservative capital structure with a debt-to-equity ratio of 0.3.
Return on Capital Employed (ROCE) has averaged 18% over the past five years, indicating that the company generates healthy returns on its invested capital. This is an important input for our DCF model because it validates that the company can reinvest capital at attractive rates of return during the projection period. For a deeper understanding of these metrics, review What Is ROCE (Return on Capital Employed)?
Revenue & Cash Flow Projections
Based on historical trends and industry analysis, we project Precision Engineering's revenue growth to moderate from 12% to 10% in Year 1, 9% in Year 2, 8% in Year 3, and stabilize at 7% in Years 4 and 5. This reflects the company's maturing business and increased competition. EBITDA margins are assumed to remain stable at 20% due to the company's pricing power and cost control measures. We project depreciation at 4% of revenue, consistent with historical trends.
Capital expenditure is projected at 5.5% of revenue, slightly above the historical average, to fund growth initiatives. The incremental capex above depreciation represents growth investments. Working capital changes are projected based on historical turnover ratios: DSO of 45 days, DPO of 35 days, and DIO of 60 days. The cash tax rate is assumed at 25%, the effective rate the company has historically paid. Based on these assumptions, we project free cash flow to grow from Rs 96 crore in the base year to Rs 155 crore in Year 5.
Our key assumptions are conservative relative to historical performance. We are not assuming margin expansion or accelerating growth, which provides a margin of safety in our valuation. The projected free cash flow growth rate of approximately 10% CAGR over the projection period is below the company's historical earnings growth rate, reflecting our conservative stance. For guidance on building these projections, see How to Build a Simple Earnings Forecast Model.
Calculating WACC
The Weighted Average Cost of Capital (WACC) represents the minimum return that Precision Engineering must earn on its investments to satisfy both debt and equity holders. We calculate WACC using the following components. The risk-free rate is the 10-year Indian government bond yield at 7.0%. The equity risk premium for Indian equities is estimated at 7.5%. Precision Engineering's beta is 0.9, indicating slightly lower volatility than the market.
Using the Capital Asset Pricing Model (CAPM), the cost of equity is: Risk-free rate (7.0%) + Beta (0.9) × Equity risk premium (7.5%) = 13.75%. The pre-tax cost of debt is estimated at 8.5%, based on the company's credit rating. After the tax shield (25% tax rate), the after-tax cost of debt is: 8.5% × (1 - 0.25) = 6.375%. The company's capital structure is 23% debt (D/EV) and 77% equity (E/EV), based on current market values.
The WACC is calculated as: (Cost of equity × E/EV) + (After-tax cost of debt × D/EV) = (13.75% × 0.77) + (6.375% × 0.23) = 10.58% + 1.47% = 12.05%. We round this to 12% for simplicity. A 12% discount rate is reasonable for a well-established Indian manufacturing company with a strong balance sheet. If the company were smaller or had higher business risk, we would use a higher discount rate. For a detailed explanation, see Understanding WACC (Weighted Average Cost of Capital).
Terminal Value & DCF Output
The terminal value represents the value of Precision Engineering's cash flows beyond the five-year projection period. We use the perpetuity growth method, which assumes that free cash flow grows at a constant rate forever. We assume a terminal growth rate of 4%, which is below India's nominal GDP growth rate, reflecting the conservative assumption that the company will grow with the economy in perpetuity.
The terminal value is calculated as: FCF in Year 5 × (1 + growth rate) / (WACC - growth rate). Using our projections: Rs 155 crore × (1.04) / (0.12 - 0.04) = Rs 161.2 crore / 0.08 = Rs 2,015 crore. We then discount this terminal value back to present value: Rs 2,015 crore / (1.12)^5 = Rs 1,143 crore. The present value of the projected free cash flows (Years 1-5) is Rs 478 crore. The total enterprise value is Rs 1,143 crore + Rs 478 crore = Rs 1,621 crore.
To arrive at equity value, we subtract net debt of Rs 200 crore and add cash of Rs 30 crore: Enterprise value (Rs 1,621 crore) - Net debt (Rs 170 crore) = Rs 1,451 crore equity value. Dividing by 5 crore outstanding shares gives an intrinsic value of Rs 290 per share. At the current market price of Rs 480, the stock appears overvalued by approximately 40% based on our base case DCF assumptions. This suggests that the market is pricing in higher growth or lower risk than our conservative assumptions imply. For more on terminal value calculations, review How to Calculate Terminal Value in DCF.
Sensitivity Analysis & Investment Decision
Given the sensitivity of DCF to key assumptions, we perform a sensitivity analysis varying the terminal growth rate and WACC. At a WACC of 11% and terminal growth of 5%, the intrinsic value increases to Rs 410 per share. At a WACC of 13% and terminal growth of 3%, the intrinsic value drops to Rs 210 per share. Across a reasonable range of assumptions, the intrinsic value ranges from Rs 210 to Rs 410 per share, with our base case of Rs 290 near the midpoint. The current market price of Rs 480 is above even the most optimistic scenario in our sensitivity range.
Sensitivity to revenue growth assumptions is also significant. If we assume the company can sustain 12% revenue growth for five years instead of our base case of 7-10%, the intrinsic value increases to Rs 360 per share. However, even this optimistic scenario suggests the stock is overvalued at Rs 480. The key insight is that for the stock to be fairly valued at current levels, the company would need to achieve higher growth or margins than its historical performance suggests.
Based on our DCF analysis, we conclude that Precision Engineering is overvalued at its current market price of Rs 480. Our base case intrinsic value of Rs 290 provides a 40% margin of safety below the current price. However, we acknowledge that DCF has limitations and should be used alongside other valuation methods. We would recommend investors wait for a lower entry price closer to Rs 300-350 before establishing a position in this otherwise high-quality company. For a broader perspective on valuation techniques, see Relative Valuation vs Absolute Valuation Explained.
Frequently asked questions
How to value a company using DCF?
To value a company using DCF, follow these steps: (1) Project free cash flows for 5-10 years based on historical performance and growth assumptions; (2) Calculate the terminal value at the end of the projection period using either the perpetuity growth method or the exit multiple method; (3) Determine the discount rate (WACC) based on the company's cost of equity and cost of debt; (4) Discount all future cash flows and the terminal value back to the present using the WACC; (5) Sum the present values to get the enterprise value; (6) Subtract net debt and add cash to arrive at equity value; (7) Divide by shares outstanding to get intrinsic value per share.
What is a good DCF example?
A good DCF example uses a real company with publicly available financial data. For instance, valuing HDFC Bank using DCF would involve analyzing its historical loan growth, net interest margins, and provision trends, then projecting future free cash flows to equity. The example should include explicit assumptions about revenue growth, operating margins, capital expenditure, working capital changes, and the discount rate. A strong DCF example will also include a sensitivity analysis showing how changes in key assumptions affect the final valuation, giving the investor a range of possible intrinsic values rather than a single point estimate.
How to project cash flows for DCF?
To project cash flows for a DCF, start with historical financial data for at least 3-5 years. Forecast revenue based on historical growth rates adjusted for industry trends, company-specific drivers (market share, new products, pricing power), and macroeconomic factors. Project operating expenses as a percentage of revenue based on historical margins and expected operating leverage. Estimate capex as a percentage of revenue or based on maintenance capex plus growth capex. Forecast working capital changes by analyzing historical trends in DSO, DPO, and DIO. Finally, calculate free cash flow as: EBITDA minus taxes minus capex minus change in working capital.
What WACC to use for Indian companies?
For Indian companies, the WACC typically ranges from 10% to 16%, depending on the company's risk profile, sector, size, and capital structure. The cost of equity is calculated using CAPM: Risk-free rate (typically the 10-year Indian government bond yield, currently around 7%) plus beta times equity risk premium (typically 6-8% for Indian equities). The cost of debt is the company's pre-tax borrowing rate adjusted for the tax shield. For a large-cap Indian company like Reliance or TCS, the WACC might be around 10-12%, while for a small-cap company it could be 14-16%.
How sensitive is DCF to assumptions?
DCF is highly sensitive to assumptions, particularly the terminal growth rate and the discount rate (WACC). A 1% change in the terminal growth rate can change the valuation by 15-25%. Similarly, a 1% change in WACC can change the valuation by 10-20%. Revenue growth assumptions in the projection period also have a significant impact. This is why professional analysts always include a sensitivity analysis table showing how the valuation changes across a range of growth rates and discount rates, rather than presenting a single target price. The DCF should be used as a range of possible values, not a precise number.
What is a reasonable intrinsic value range?
A reasonable intrinsic value range from a DCF analysis depends on the company's predictability and stability. For a stable, predictable company like Hindustan Unilever or Colgate-Palmolive in India, the range might be within 10-15% of the midpoint estimate because cash flows are relatively predictable. For a cyclical or high-growth company, the range could be 30-50% or more. If the current market price is at the lower end of your intrinsic value range, the stock may be undervalued. If it is at the upper end or above, the stock may be fairly valued or overvalued.
DCF valuation is a powerful tool for determining the intrinsic value of a company, but it requires careful assumptions and sensitivity analysis. By applying the techniques demonstrated in this case study, you can make more informed investment decisions. Continue your learning journey with our guide on Sensitivity Analysis in DCF Valuation. This content is educational and does not constitute financial advice.