Equity research and valuation: DCF and multiples

In short

Equity research estimates what a business is worth and compares that with its market price to recommend buy, hold or sell. Two families of methods dominate: intrinsic valuation, chiefly discounted cash flow (DCF), which discounts forecast free cash flows at the cost of capital; and relative valuation, using multiples such as P/E and EV/EBITDA against peers or past deals. The topic is examined in MBA Security Analysis, Corporate Valuation and Equity Research papers, and in NISM Series-XV (Research Analyst) and CFA Level I/II. It is the core technical screen for jobs at Indian sell-side and buy-side desks (Motilal Oswal, Kotak Institutional Equities, ICICI Securities, Axis Capital, JM Financial), global capability centres (Morgan Stanley, Goldman Sachs, Nomura, UBS, Evalueserve, Acuity Knowledge Partners) and valuation teams at the Big Four.

Explained

What an equity research analyst actually produces

• Initiating coverage note — business description, industry structure, revenue drivers, forecasts, valuation, risks, with a target price (TP) and rating; typically 12-month TP.
• Flash / results update — actual versus estimates, management guidance from the earnings call, revision to estimates and TP.
• Three-statement model feeding the valuation: P&L, balance sheet, cash flow, driver schedules (volume × realisation, store count × revenue per store, AUM × yield).
• Rating scale is relative to TP upside: typically Buy (>15% upside), Hold / Neutral, Sell. Each house defines its own bands.
• Regulation (India): research analysts and their firms must be registered with SEBI under the SEBI (Research Analysts) Regulations, 2014, which mandate qualification and NISM certification, disclosure of the analyst's and firm's holdings and conflicts, and no front-running; compliance details have been amended several times, most recently to revise net-worth, deposit and record-keeping norms, so quote the current circular rather than old thresholds. Accounts are read under Ind AS (Companies (Indian Accounting Standards) Rules, 2015) for listed companies.
• Sell-side publishes for clients and earns from broking/corporate access; buy-side (mutual funds, insurers, PMS, AIFs) writes internally to decide portfolio positions.

Intrinsic valuation: the DCF

• Principle: value = present value of expected future cash flows, discounted at a rate reflecting their risk. Only *free* cash flow counts — cash available after reinvestment needed to sustain the forecast.
• Two consistent routes:
  • FCFF (firm) → discount at WACC → Enterprise Value (EV) → subtract net debt → equity value. Preferred for levered companies or changing capital structure.
  • FCFE (equity) → discount at cost of equity Ke → equity value directly. Natural for banks and NBFCs, where debt is raw material, not financing.
• Steps:
  1. Forecast horizon: explicit forecasts for 5-10 years, until the business reaches steady state (growth ≤ nominal GDP, stable margins, ROIC converging towards WACC).
  2. Forecast FCFF from EBIT: tax the EBIT, add back non-cash depreciation and amortisation, subtract capex and the increase in non-cash working capital.
  3. Discount rate: WACC from market-value weights; Ke from CAPM using the 10-year G-Sec yield as risk-free rate, an equity risk premium (India commonly 6-8%, house-specific), and a beta regressed against Nifty 50 or Sensex, usually unlevered and relevered to the target capital structure.
  4. Terminal value (TV) at the end of the horizon — usually 60-80% of total value, so assumptions here dominate.
  5. Discount explicit FCFF and TV to today; mid-year convention (discount by t − 0.5) if cash arrives through the year.
  6. Bridge EV to equity: subtract gross debt, add cash and cash equivalents, subtract minority interest and unfunded pension/ESOP overhang, add the market value of non-core investments and surplus land.
  7. Per share: equity value ÷ diluted shares (treasury-stock method for options/warrants); add back the 12-month roll-forward to get a forward TP.
• Terminal value methods:
  • Gordon / perpetuity growth: TV = FCFF(n+1)/(WACC − g). Discipline: g must not exceed long-run nominal growth (for India, roughly 4-6% real plus inflation; most notes use 4-5.5% nominal in rupee models and justify it).
  • Exit multiple: TV = terminal-year EBITDA × an exit EV/EBITDA. Easy to communicate, but imports a market multiple into an "intrinsic" model — cross-check the implied g.
• Advantages: forward-looking, forces explicit assumptions, usable for loss-making companies that will later turn cash-positive, insensitive to short-term market sentiment.
• Limitations: extreme sensitivity to WACC and g, garbage-in-garbage-out forecasts, terminal-value dominance, unusable for pre-revenue or distressed firms without scenario work, and no help on timing.
• Variants: dividend discount model (DDM) for stable dividend payers and banks; excess return / EVA models; residual income for financials; adjusted present value when the tax shield is modelled separately.

Relative valuation: multiples

• Principle: similar assets should trade at similar prices relative to a common driver — earnings, cash flow, book value, sales, or an operating unit.
• Equity multiples (numerator = market cap or share price) must be paired with a post-interest, post-minority figure: P/E, PEG, P/B, P/CF, dividend yield.
• Enterprise multiples (numerator = EV) must be paired with a pre-interest figure available to all capital providers: EV/EBITDA, EV/EBIT, EV/Sales, EV/CE, EV/FCF.
• The consistency rule: never put EV over a post-interest number or market cap over EBITDA — the classic rejection in an interview.
• Trailing vs forward: trailing uses last four reported quarters; forward (1-year, 2-year) multiples drive Indian TPs because prices discount the future. Always label: "22× FY28E EPS".
• Choosing comparables: same industry and sub-segment, similar growth, margins, capital intensity, risk, accounting policy and geography; adjust for size and liquidity. 5-10 peers is typical.
• Sector-preferred multiples (Indian practice):
  • Banks and NBFCs — P/B and P/ABV (adjusted book value, net of unprovided NPAs), cross-checked with a two-stage P/B = (ROE − g)/(Ke − g) fade model; EV is meaningless for banks.
  • IT services — P/E and EV/EBITDA; dollar-revenue growth and EBIT margin are the drivers.
  • Cement, steel, metals — EV/tonne of capacity and EV/EBITDA; EBITDA per tonne.
  • Telecom — EV/EBITDA and EV per subscriber; ARPU drives it.
  • Real estate — NAV of the project pipeline, plus price/NAV.
  • Hotels — EV per key; retail — EV/Sales and EV per square foot; power — EV/MW.
  • Internet / loss-making platforms — EV/Sales, EV/GMV, EV/take-rate, with a path-to-profitability DCF.
  • Insurance — embedded value (EV, a different "EV") and price/EV, plus VNB multiples.
• Precedent transaction multiples come from completed M&A and embed a control premium; trading comps reflect minority stakes. Hence transaction multiples usually exceed trading multiples.
• Advantages: quick, market-grounded, easily communicated, fewer assumptions, good for sanity-checking a DCF.
• Limitations: inherits any market-wide mispricing, no two companies are truly comparable, distorted by one-offs, differing accounting (Ind AS 116 lease treatment moves EBITDA sharply), differing leverage and tax rates, and useless if earnings are negative.

Making the numbers comparable: adjustments that earn marks

• Normalise earnings: strip exceptional items — asset sale gains, impairment, one-off litigation, restructuring, forex MTM on loans, ESOP charges if you treat them as non-cash (state your choice).
• Ind AS 116 (leases): operating leases sit on the balance sheet as right-of-use assets and lease liabilities; rent moves out of EBITDA into depreciation and finance cost. So EBITDA rises, debt rises. Either include lease liabilities in net debt and use post-Ind AS 116 EBITDA, or strip both — never mix.
• Net debt: gross borrowings + lease liabilities (if included) + preference shares treated as debt − cash and liquid investments. Check pledged or restricted cash and trapped overseas cash.
• Minority interest / non-controlling interest: add at market or book value to the EV bridge when EBITDA is consolidated.
• Associates and JVs: share of profit is in consolidated PAT but their EBITDA is not consolidated — value them separately or the multiple is wrong.
• Tax: use the effective cash tax rate in forecasts and the marginal statutory rate in the WACC tax shield; India's headline corporate rate is 22% plus surcharge and cess (about 25.17% effective) under the concessional regime for domestic companies that forgo incentives, and 15% plus surcharge and cess (about 17.16%) for eligible new manufacturers; MAT is 14% under the Finance Act 2026 and is now a final tax. Section numbering has changed with the Income-tax Act, 2025 effective 1 April 2026, so name the provision rather than quote an old section number.
• Buy-backs are taxed as capital gains in the shareholder's hands from 1 April 2026 — relevant when modelling shareholder-return policy.
• Dilution: convertibles, warrants, ESOPs — use diluted share count; if-converted method for convertibles.

Putting it together: triangulation and presentation

• Run DCF + trading comps + transaction comps (+ SOTP where segments differ) and present a valuation range (the "football field"), not a single number.
• SOTP (sum of the parts): value each segment on its own appropriate multiple, add, subtract net debt and a holding-company discount (commonly 20-50% in India for listed holdcos such as diversified conglomerates — the discount is observed, not derived).
• Sensitivity table: value per share against WACC (± 100 bp) and terminal growth (± 50 bp); scenario analysis (bull/base/bear) on volumes, realisations and margins.
• Implied-multiple check: back out the implied forward P/E and EV/EBITDA from your DCF value; if the DCF implies 60× when peers trade at 25×, the model, not the market, is probably wrong.
• Reverse DCF: solve for the growth and margin the current market price already implies — a strong interview answer and a fast reality check.
• Catalysts and risks must be named: capacity commissioning, tariff order, regulatory change, promoter pledge, working-capital stress, customer concentration.

Key points

• Intrinsic vs relative - DCF asks what the cash flows are worth; multiples ask what the market pays for similar cash flows.
• FCFF - EBIT(1−t) + D&A − capex − ΔNWC; cash to all capital providers; discount at WACC.
• FCFE - FCFF − interest(1−t) + net borrowing; cash to equity holders; discount at Ke.
• WACC - after-tax weighted cost of debt and equity at market-value weights, not book weights.
• CAPM - Ke = Rf + β × ERP; Rf from the 10-year G-Sec; relever beta to target debt/equity.
• Terminal value - usually 60-80% of DCF value; Gordon growth or exit multiple; g ≤ long-run nominal GDP growth.
• EV bridge - EV − net debt − minority interest + non-core assets = equity value.
• Consistency rule - EV pairs with pre-interest metrics (EBITDA, EBIT, Sales); price pairs with post-interest (EPS, book value).
• Forward multiples rule Indian target prices; always state the year ("18× FY28E EPS").
• P/E decomposition - P/E = payout × (1+g)/(Ke − g); a high P/E is justified by high growth, high ROE or low risk, not by itself.
• PEG - P/E ÷ growth %; around 1 is loosely "fair", but it assumes a linear price-growth relation.
• P/B and ROE - justified P/B = (ROE − g)/(Ke − g); banks trade above book only when ROE > Ke.
• Transaction > trading multiples because of the control premium; add control premium, deduct minority/illiquidity discounts as appropriate.
• Ind AS 116 lifts EBITDA and adds lease debt - treat leases consistently in EV and EBITDA.
• SOTP for conglomerates, with a holding-company discount; segment-appropriate multiples.
• Reverse DCF extracts the market's implied assumptions from the current price.
• Triangulate - present a range from several methods with sensitivities; a single point estimate is a red flag.
• SEBI (Research Analysts) Regulations, 2014 govern Indian research: registration, NISM certification, conflict disclosure.

Formulas and examples

Example 1 — FCFF from the P&L (₹ crore). EBIT 1,200; effective tax 25%; D&A 300; capex 450; working capital rises from 500 to 580.

• EBIT(1−t) = 1,200 × 0.75 = 900
• + D&A 300 = 1,200; − capex 450 = 750; − ΔNWC 80 = FCFF = ₹670 crore
• If interest is ₹100 crore and net borrowing ₹50 crore: FCFE = 670 − 100 × 0.75 + 50 = 670 − 75 + 50 = ₹645 crore

Example 2 — WACC. Market cap ₹8,000 crore; net-of-nothing gross debt ₹2,000 crore at 9% pre-tax; tax 25%; Rf 6.8%; β 1.1; ERP 7%.

• Ke = 6.8% + 1.1 × 7% = 14.5%
• Kd after tax = 9% × 0.75 = 6.75%
• Weights: E/V = 8,000/10,000 = 0.80; D/V = 0.20
• WACC = 0.80 × 14.5% + 0.20 × 6.75% = 11.60% + 1.35% = 12.95% (round to 13.0%)

Example 3 — Full two-stage DCF to a per-share value. FCFF forecast (₹ crore): Y1 670, Y2 740, Y3 810, Y4 880, Y5 950. WACC 13%; terminal growth 5%; gross debt ₹2,000 crore; cash ₹400 crore; minority interest ₹100 crore; diluted shares 20 crore. End-year discounting.

• TV = 950 × 1.05 / (0.13 − 0.05) = 997.5 / 0.08 = ₹12,468.8 crore
• PV of TV = 12,468.8 × 0.5428 = ₹6,768.1 crore (TV is 70.8% of EV — note the dominance)
• EV = 2,789.1 + 6,768.1 = ₹9,557.2 crore
• Equity value = 9,557.2 − 2,000 + 400 − 100 = ₹7,857.2 crore
• Value per share = 7,857.2 / 20 = ₹392.9 ≈ ₹393
• Implied check: if terminal-year EBITDA is ₹1,900 crore, the TV implies an exit EV/EBITDA of 12,468.8/1,900 = 6.6× — plausible for an industrial, low for a consumer name.

Example 4 — Sensitivity of the same DCF (value per share, ₹). Recomputing Example 3 at each pair:

• A 100 bp move in WACC shifts the base value from ₹393 to ₹462 or ₹339 — roughly +18% / −14%. This spread, not the point estimate, is the honest output.

Example 5 — Multiples and the EV bridge. Share price ₹400; 20 crore shares; gross debt ₹2,000 crore; cash ₹400 crore; minority ₹100 crore; FY28E EBITDA ₹1,500 crore; FY28E PAT ₹700 crore; book value ₹4,000 crore.

• Market cap = 400 × 20 = ₹8,000 crore
• EV = 8,000 + 2,000 + 100 − 400 = ₹9,700 crore
• EV/EBITDA = 9,700/1,500 = 6.47×; EPS = 700/20 = ₹35 → P/E = 400/35 = 11.4×; P/B = 8,000/4,000 = 2.0×
• Peer median is 8.0× EV/EBITDA → implied EV = 1,500 × 8.0 = ₹12,000 crore → equity = 12,000 − 2,000 + 400 − 100 = ₹10,300 crore → ₹515 per share, i.e. 29% upside.
• Triangulation: DCF ₹393, comps ₹515, DCF sensitivity band ₹339-₹462 → publish a range of about ₹390-515 and a TP near the weighted middle, stating the weights.

Example 6 — Justified multiples. ROE 18%, Ke 13%, g 6%, so retention = g/ROE = 6/18 = 33.3% and payout = 66.7%.

• Justified P/B = (0.18 − 0.06)/(0.13 − 0.06) = 0.12/0.07 = 1.71×
• Justified P/E = 0.667 × 1.06 / 0.07 = 0.7067/0.07 = 10.1×
• Cross-check: P/E × ROE = 10.1 × 0.18 = 1.82 ≈ P/B 1.71 (small gap from rounding and the (1+g) term) — the identity P/B = P/E × ROE holds approximately.

Where it is used

• Sell-side research at Indian brokerages (Motilal Oswal, Kotak Institutional Equities, ICICI Securities, Axis Capital, HDFC Securities, JM Financial) — sector coverage, earnings previews, TP revisions after quarterly results.
• Buy-side at mutual funds and insurers (HDFC AMC, SBI MF, ICICI Prudential AMC, SBI Life) and at PMS/AIF and hedge funds — internal notes and position sizing.
• Investment banking and private equity — DCF and precedent transactions for fairness opinions, open-offer pricing under the SEBI Takeover Regulations, IPO pricing and PE/VC entry valuations.
• Registered Valuers under the Companies Act, 2013 (section 247) and IBBI registration — valuation reports for schemes of arrangement, ESOP, and insolvency resolution; Indian Valuation Standards issued by ICAI are commonly applied alongside the IBBI framework.
• Global capability centres and KPOs in Bengaluru, Gurugram, Mumbai and Pune (Morgan Stanley, Goldman Sachs, Nomura, UBS, Evalueserve, Acuity Knowledge Partners, Aranca) — model building and comps maintenance for offshore desks.
• Corporate strategy, FP&A and credit teams — business-case NPVs, segment value tracking, and EV/EBITDA covenant and headroom analysis.

Interview questions

• Q: Walk me through a DCF. A: Forecast FCFF for 5-10 years, discount at WACC, add a terminal value from perpetuity growth or an exit multiple, discount that too, sum for enterprise value, then subtract net debt and minority interest and divide by diluted shares.
• Q: Why discount FCFF at WACC and FCFE at the cost of equity? A: FCFF belongs to all capital providers, so it must be discounted at their blended required return; FCFE is what is left for shareholders after debt service, so only the cost of equity applies. Mixing them double-counts or omits the debt effect.
• Q: Which is more sensitive, WACC or terminal growth? A: Both move value sharply because the terminal value is 60-80% of the total; in the (WACC − g) denominator a 100 bp WACC change usually matters more than a 50 bp g change, which is why a sensitivity grid is published instead of one number.
• Q: Can terminal growth exceed GDP growth? A: No — in perpetuity the firm would eventually become larger than the economy, so g is capped at long-run nominal GDP growth and in practice set below it.
• Q: Why is EV/EBITDA preferred to P/E when comparing companies? A: EV/EBITDA is independent of capital structure and of depreciation and tax policy, so it compares operating businesses with different leverage; P/E is distorted by interest, tax rates and one-offs.
• Q: When would you not use EV/EBITDA? A: For banks and NBFCs, where debt is raw material and EV is meaningless — use P/B, P/ABV or a residual-income or FCFE model; also where capex intensity differs sharply, since EBITDA ignores it.
• Q: Two identical companies, one with higher debt — which has the higher P/E? A: Typically the levered one has lower equity value and lower earnings; P/E can go either way, but its equity is riskier so it usually deserves a lower P/E — which is exactly why EV/EBITDA is the cleaner comparison.
• Q: Why do transaction multiples exceed trading multiples? A: Deal prices include a control premium and expected synergies, while trading multiples price minority, non-controlling stakes.
• Q: How does Ind AS 116 change EV/EBITDA? A: Operating lease rent leaves EBITDA, lifting it, while a lease liability is added to debt and so to EV; both numerator and denominator rise, so you must treat leases consistently across all peers.
• Q: What is a reverse DCF and why is it useful? A: You hold the current market price fixed and solve for the growth or margin it implies; it tells you whether the market's embedded assumptions are achievable, without needing your own forecast.
• Q: A company has negative EBITDA — how do you value it? A: Use EV/Sales or EV/GMV against peers, and build a DCF to the year it turns cash-positive with scenario weights; a loss-making multiple otherwise has no meaning.
• Q: Your DCF says ₹393 and peers imply ₹515. What do you tell the client? A: Publish the range, explain the gap — usually the DCF's terminal assumptions or the peer set's growth differential — and check the DCF's implied exit multiple against peers before trusting either.
• Q: Which number do you trust more, DCF or multiples? A: Neither alone; multiples anchor the model to observable market pricing, the DCF tests whether that pricing is defensible on cash flows, and the disagreement between them is itself the insight.

Common mistakes

• Pairing EV with a post-interest metric (EV/PAT) or market cap with EBITDA — the consistency rule broken.
• Forgetting the EV bridge: reporting enterprise value as the share value, or omitting minority interest, lease liabilities or non-core assets.
• Using book-value weights instead of market-value weights in WACC, or using the coupon on old debt instead of the current marginal cost of debt.
• Setting terminal growth at 8-10% "because India grows fast", or applying the Gordon formula to year n's FCFF without the (1+g) step.
• Double-counting the tax shield — using after-tax Kd in WACC and also subtracting interest from FCFF.
• Comparing a trailing multiple of one company with a forward multiple of another, or not normalising one-off gains and losses.
• Mixing consolidated EBITDA with standalone net debt, or valuing associates twice (once in PAT, once as an investment).
• Reporting a single point target price with no sensitivity, scenario or implied-multiple cross-check.

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