DCF is the only method that values your business on its own future rather than someone else's past transaction. It is also the easiest method to accidentally manipulate.
The core idea
A dollar you receive in five years is worth less than a dollar today, because of risk and because today's dollar can be invested. DCF forecasts the cash the business will generate, converts each future year into today's money using a discount rate, and adds them up.
Step 1 — Forecast free cash flow
Start from normalised EBITDA. Deduct tax, add or subtract the change in working capital, then deduct capital expenditure. What remains is free cash flow to the firm. Forecast five years explicitly; beyond that, precision is an illusion.
Step 2 — Choose a discount rate
For private businesses the discount rate is usually built up: a risk-free rate, plus an equity market premium, plus a size premium, plus a company-specific premium for owner dependence, customer concentration and forecast reliability. Small private businesses commonly land between 18% and 30%. If your rate looks like a listed company's, you have understated risk.
Step 3 — Terminal value
Terminal value captures everything after the forecast window and often represents 50–70% of the total. Two accepted approaches: capitalise the final year's cash flow using the Gordon growth formula, or apply an exit EBITDA multiple. Long-term growth should not exceed the economy's nominal growth rate — 2–3% is defensible, 8% is not.
Anyone can justify any valuation with a DCF. The discipline is in the assumptions, not the arithmetic.
Step 4 — Sensitivity testing
Run the model with the discount rate one and two points higher and lower, and with terminal growth flexed. Present the resulting grid. A DCF that produces one number is a sales document; a DCF that produces a range is a valuation.
When DCF is the wrong tool
- Volatile earnings with no reliable forecast basis
- Businesses whose value is essentially their asset base
- Very small owner-operated businesses, where market multiples dominate
- Pre-revenue ventures, where scenario methods such as First Chicago fit better
In practice DCF works best as a cross-check on a multiple-based valuation. When the two agree, confidence rises; when they diverge, one of your assumptions needs work.