Discounted Cash Flow (DCF) Analysis: Step-by-Step

What DCF Tells You

A Discounted Cash Flow analysis values a business based on the present value of its expected future cash flows. The core principle is straightforward: a dollar received today is worth more than a dollar received next year because of the time value of money and risk. By projecting future cash flows and discounting them back to today, DCF attempts to determine the intrinsic value of a business independent of market sentiment or comparable transactions.

Step 1: Project Free Cash Flows

Start by projecting the business's Free Cash Flow (FCF) for 5-10 years. FCF is calculated as:

• EBITDA
• Minus taxes
• Minus capital expenditures
• Minus changes in working capital

Base your projections on historical performance, adjusted for known changes in the business environment. Use conservative growth assumptions: most DCF models overstate growth because of optimism bias. For private businesses, projecting 5 years is standard; longer horizons introduce too much uncertainty.

Step 2: Determine the Discount Rate

The discount rate reflects the required return on investment, incorporating the time value of money and the specific risks of the business. For private companies, the discount rate typically ranges from 15-30%, significantly higher than public company rates due to illiquidity, concentration risk, and information asymmetry.

The build-up method is commonly used for private businesses: start with the risk-free rate (Treasury yield), add an equity risk premium, a size premium, an industry risk adjustment, and a company-specific risk premium. Each component should be justified and documented.

Step 3: Calculate Terminal Value

Since you cannot project cash flows indefinitely, a terminal value captures all value beyond the projection period. The two common methods are the Gordon Growth Model (which assumes cash flows grow at a constant rate perpetually) and the exit multiple method (which applies an industry multiple to the final year's earnings).

Terminal value often represents 50-75% of total DCF value, which is both a feature and a vulnerability of the method. Small changes in the terminal growth rate or exit multiple have an outsized impact on the final valuation.

Step 4: Discount and Sum

Discount each year's projected FCF and the terminal value back to present using the discount rate. Sum these present values to arrive at the enterprise value. Subtract net debt to determine equity value.

Always run sensitivity analysis on key inputs: what happens to value if growth is 2% lower? If the discount rate increases by 3 points? If margins compress? A robust DCF presents a range of values, not a single number, and the width of that range tells you about the uncertainty inherent in the valuation.