Beyond P/E Ratios: Using DCF Models to Think About Company Value Like a CEO

In investment discussions, the most commonly mentioned valuation metric is the price-to-earnings (P/E) ratio. It's simple and intuitive, but sometimes extremely misleading. If a temporarily loss-making but high-potential growth company has a negative P/E, is it worthless? If a stable but no-growth utility company has a low P/E, is it necessarily cheap?

To gain deeper understanding of a company's intrinsic value, professional investors and corporate M&A teams often use a more fundamental thinking tool—the Discounted Cash Flow (DCF) model.

The purpose of this article is not to teach you how to build a complex Excel model, but to share the core concepts of DCF to help us establish a more comprehensive valuation learning framework.

What is Discounted Cash Flow (DCF)?

Imagine you want to buy a mango tree. How would you value it? You probably wouldn't just look at how many mangoes it produced last year, but would predict how many mangoes it could produce annually for the next 10, 20, or even more years. Then, considering future uncertainty (like weather, pests) and the time value of money (100 rupees next year isn't worth as much as 100 rupees today), you would apply a discount to all expected future mango harvests and "discount" them to today's value, arriving at a total value.

DCF models value companies in the same way. It believes that a company's value equals the sum of all its future free cash flows (FCF), discounted to present value. Here, "free cash flow" refers to the money that a company can truly distribute freely to shareholders and creditors after paying all operating costs and reinvestment requirements.

Two Core Elements of DCF Models

1. Forecasting Future Cash Flows

This is the most artistic part of DCF analysis. We need to predict a company's revenue growth rate, profit margins, and required reinvestment for the next 5 to 10 years based on our understanding of its business, industry prospects, and competitive landscape. This forces us to think: How deep is this company's moat? Does its product have pricing power? What's the industry's ceiling?

2. Choosing an Appropriate Discount Rate

The higher the risk of future cash flows, the larger the "discount" we require—this discount rate is the discount rate. It's usually calculated using the Weighted Average Cost of Capital (WACC), combining the cost of equity (minimum return required by shareholders) and cost of debt (interest rate for company borrowing). A high-risk startup might have a discount rate of 20%-30%; while a mature, stable utility company might only have 8%-10%.

Why is DCF Thinking So Important?

Even if we don't calculate it ourselves, understanding DCF logic can greatly improve our analytical abilities:

Of course, DCF models also have limitations—they heavily depend on assumptions: "garbage in, garbage out." But they provide a rigorous thinking framework, helping us translate qualitative understanding of a company (like brand, management) into quantitative valuation thinking.