DCF valuation explained
Discounted cash flow without the spreadsheet mysticism — what the discount rate actually represents, why terminal value is usually most of the answer, and when a DCF is worth building.
A discounted cash flow says one thing: money you will receive in 2031 is worth less than money you receive today, and here is exactly how much less. Everything else is bookkeeping around that sentence.
The mechanic, in one table
Forecast the cash the business will generate, then reduce each future year by a rate that reflects how uncertain it is.
| Year | Free cash flow | Discounted at 18% |
|---|---|---|
| 2027 | €420,000 | €356,000 |
| 2028 | €470,000 | €338,000 |
| 2029 | €510,000 | €311,000 |
| 2030 | €540,000 | €279,000 |
| 2031 | €560,000 | €245,000 |
Five years of forecast cash worth €2.5M in nominal terms is worth €1.53M today. The €970,000 difference is the price of waiting and the risk of being wrong.
What the discount rate actually is
Not a technical parameter. It is the return a buyer needs to justify taking this risk instead of a different one.
- Listed equities
- 8–10%
- liquid, diversified
- Mid-market private
- 12–18%
- illiquid, concentrated
- Owner-managed SME
- 18–25%
- key-person risk, thin buyer pool
An owner using 10% for a business that depends on them personally is not being optimistic — they are pricing their company as if it were a diversified portfolio.
Terminal value is usually most of the answer
Nobody forecasts to infinity, so the years beyond the horizon are compressed into one figure — terminal value — and then discounted like everything else.
For an SME DCF, terminal value routinely accounts for 60% to 75% of the total. Which means most of your carefully modelled five-year forecast is decoration around a single assumption about what happens afterwards.
Two ways to set it, and they disagree on purpose:
| Method | How | Watch for |
|---|---|---|
| Perpetuity growth | Final year cash ÷ (rate − growth) | Growth above 2–3% assumes you outgrow the economy forever |
| Exit multiple | Final year EBITDA × a multiple | You have reintroduced the multiple you were trying to avoid |
Run both. If they differ by more than a third, one of your assumptions is doing too much work.
When a DCF earns its keep
The honest limitation
A DCF is arithmetic applied to guesses. Its value is not the number it produces — it is that every guess has to be written down where someone can disagree with it. That is also why buyers like it and sellers sometimes regret it.
How to value a business puts the DCF next to the other two methods; common valuation mistakes covers the forecast errors that make a DCF worse than useless.