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What Is Discounted Cash Flow?

5 minute read

What Is Discounted Cash Flow?

Discounted cash flow term on blue background.
The BizBuySell Team

Discounted Cash Flow (DCF) is a valuation method that estimates a business's true worth by calculating the present value of its future cash flows. As a small business owner, understanding your business's value helps you make informed decisions about investments, growth strategies, and potential sale of your business.

But how do you figure out what your business is worth? Isn't that what financial statements, like the balance sheet, show?

There are actually three common valuation methods. One of them, the asset-based method, uses the owners' equity from the balance sheet. However, these numbers rarely represent the business's true value.

That's because accounting is based on past performance. Financial statements show what has already happened, not what will happen in the future.

That's why alternative valuation methods, such as income-based approaches like the discounted cash flow (DCF), are used to give a more accurate picture of a business's worth.

What Is the Discounted Cash Flow Method?

The DCF method is a type of income-based valuation that values a business by estimating the net present value (NPV) of its future cash flows, accounting for the time value of money.

Many consider this valuation model the gold standard for determining the value of an investment.

Advantages of the DCF Method

The DCF method is useful for several reasons.

  1. It considers the time value of money. A dollar today is worth more than a dollar tomorrow. That's because you can invest the money today to earn returns. Also, inflation reduces the value of money over time, which lowers the value of the cash today.
  2. It focuses on future cash flows. Unlike methods that rely on past financial data, the DCF method looks at future cash flows to assess growth potential.
  3. It calculates a company's true worth. DCF analysis measures the intrinsic value of a business based on its own financials. The benefit is that you don't have to compare it to other companies.

For business sellers and buyers, DCF analysis provides a powerful negotiation tool. Sellers can justify higher asking prices by demonstrating strong projected cash flows, while buyers can use DCF to determine a fair offer price and avoid overpaying. Business brokers often use DCF alongside other methods to establish realistic market valuations that satisfy both parties.

Limitations of the DCF Method

Despite its strengths, the DCF method has some downsides:

  1. It relies on assumptions. Since the DCF method makes assumptions about future cash flow projections, there's a risk of inaccuracy.
  2. It can be hard to apply in some cases. Businesses in unstable industries, startups with negative cash flow, or companies with unpredictable revenue may struggle with accurate forecasting.

How the Discounted Cash Flow Method Works

To use the DCF method, follow these steps:

  1. Estimate cash flow projections. Use realistic assumptions about future revenues, expenses, growth rates, inflation, and other factors.
  2. Choose a discount rate. This reflects both the time value of money and the investment's risk.
  3. Calculate the present value. Use the discount rate to determine what those future cash flows are worth today.

The DCF Formula

Most businesses have two types of investors:

  1. Debt holders: Lenders whose expected rate of return is usually interest on the initial investment.
  2. Equity holders: Shareholders whose expected rate of return is mainly the cash through dividends.

The discounted cash flow formula below is the first component of the DCF model: the forecast time period, which is the years that cash flows can be predicted with some level of confidence.

Discounted Cash Flow Formula

The formula for DCF is:

DCF = CF1 / (1+r)1 + CF2 / (1+r)2 + CFn / (1+r)n

where:

  • CF1 = The cash flow for year one
  • CF2 = The cash flow for year two
  • CFn = The cash flow for additional years
  • r = The discount rate

The second component is the terminal value, which is the estimated value of the business after the forecast period. It assumes that growth is stable and will continue indefinitely, so the forecasted cash flows can be predicted confidently.

The formula for terminal value is:

TV = (FCFn × (1 + g)) / (Discount rate – g)

Where inputs are:

  • TV = terminal value
  • FCFn = cash flow in the final year of the forecast period
  • g = perpetual growth rate of future cash flow

The DCF Calculation: Step-by-step Example

Let's say we want to calculate the value of a business with the following estimates:

  • Year 1 expected cash flow (CF1): $30,000
  • Year 2 expected cash flow (CF2): $40,000
  • Year 3 expected cash flow (CF3): $50,000
  • Discount rate (also known as the weighted average cost of capital): 10%
  • Growth rate (g): 2%

Step 1: Calculate the discounted cash flow

  • Year 1: $30,000/(1.1) = $27,272
  • Year 2: $40,000/(1.1)2 = $33,058
  • Year 3: $50,000/(1.1)3 = $37,566

The total DCF for the first three years is $97,896.

Step 2: Calculate terminal value

TV = (FCFn × (1 + g)) / (WACC – g)
TV = ($50,000 × (1 + 2%)) / (10% – 2%) = $51,000/8%
TV = $637,500

Step 3: Add everything together

The total value of this business according to the DCF valuation method is $97,896 + $637,500 = $735,396.

The Valuation Context of the Discounted Cash Flow Method

The DCF method stands out among income-based approaches because it determines the intrinsic value of the business based on its own financial characteristics rather than using market comparisons.

As our valuation guide explains, the three main valuation methods include:

  • Market-based valuation: Uses comparable sales and industry multiples to determine value
  • Asset-based valuation: Adds up all a business's assets, but ignores future potential
  • Income-based valuation: Focuses on projected earnings, including both capitalization of earnings and DCF approaches

While all these methods can be useful depending on the business circumstances, the DCF model provides a more forward-looking and precise valuation for businesses with predictable earnings.

Using DCF in Business Acquisitions

Once you've calculated a business's value using DCF, you can:

  • Compare it to the asking price to determine if the business is potentially under or overvalued
  • Test different scenarios by adjusting growth rates or discount rates
  • Use the analysis to secure financing by showing lenders the projected return on investment
  • Structure earn-out agreements based on the projected future cash flows

BizBuySell has many tools and resources to help you get started on determining the worth of a business—whether your buying, selling, or just looking for a market valuation: