DCF

What it means

DCF, short for discounted cash flow, is a method of business valuation or project appraisal based on a simple idea: a company is worth the cash it will generate in the future. Future free cash flows are converted to present value and added up.

There are three steps. First a forecast of free cash flows is built for five to ten years, then the discount rate is set, usually the WACC, and finally a terminal value beyond the forecast period is calculated, which often makes up most of the result.

The result is the value of the whole enterprise. Subtracting net debt gives the equity value, meaning what the shareholders’ stakes should be worth. For projects the principle is the same as for NPV.

How it works in practice

DCF is used when buying or selling a business, when an investor comes in, in shareholder disputes over the value of a stake and in impairment tests in the accounts. Valuers combine it with comparisons to market transactions and with an asset-based valuation.

For small and medium-sized companies the biggest challenge is a credible plan. We start from the accounting history, cleaned of one-off items and the owner’s private expenses, and from actual contracts and trends, so that the valuation survives the buyer’s due diligence.

Because the result is sensitive to assumptions, we always add a sensitivity analysis of the discount rate and growth, and scenarios. Buyer and seller then see a range of values rather than one number with false precision.

What to watch out for

A small change in assumptions moves the result considerably. One percentage point in the discount rate or long-term growth can change the value by tens of percent, so every assumption should be justified and documented.

A common mistake is a terminal value assuming growth above the economy’s long-term rate, or a plan in which sales grow while investment and working capital do not. Such a valuation looks good on paper but does not hold up in negotiations with a buyer.