What a discounted cash flow valuation does
A discounted cash flow (DCF) valuation forecasts the cash a business is expected to generate each year, then converts those future amounts into a single present value using a discount rate. Cash received in five years is worth less today than the same cash received next year, both because of the time involved and because of the risk that it never arrives. The discount rate captures both.
The method is explicit about timing, which is its strength. Instead of assuming that one figure for earnings will repeat indefinitely, as the capitalisation of earnings method does, a DCF can model a business whose cash flows rise, fall or stop. That flexibility is also its weakness, because every year of the forecast is an assumption that has to be defended.
The forecast period and the terminal value
Most small business DCF models forecast three to five years in detail. Beyond that, the model either assumes the business ends, which suits a fixed-term contract or a licence with an expiry date, or applies a terminal value that represents all the cash flows after the explicit period. The terminal value is usually calculated by capitalising the final year's cash flow at a long-term growth rate, or by applying an exit multiple.
In a typical model the terminal value accounts for well over half of the total, sometimes much more. That means a DCF for a business expected to trade indefinitely is, in substance, a capitalisation of earnings valuation with a few years of explicit forecast in front of it. If the forecast years are not materially different from a stable run rate, the extra complexity adds little.
The discount rate in plain terms
The discount rate is the annual return an investor would require to accept the risk of the forecast cash flows. For a whole business it is usually expressed as a weighted average cost of capital (WACC), which blends the return required by equity owners with the after-tax cost of any debt, weighted by the proportion of each in a normal capital structure for that kind of business.
For a small private business the equity component dominates and is built up from a risk-free rate, a premium for equity risk generally, and further premiums for size, lack of marketability and the specific risks of the business. Those specific premiums involve judgement. A report should show the build-up and explain each step, because a difference of a few percentage points in the rate can move the value by a large margin.
Why the result is so sensitive to assumptions
A DCF has more moving parts than a single-figure method, and small changes compound across the forecast. Growth rates, margins, the reinvestment needed to support growth, the terminal growth rate and the discount rate all interact. A model that looks precise to the dollar can be resting on assumptions that are little more than hopes.
Hypothetical sensitivity of a DCF result (all figures assumed for the example)
| Assumption changed | Discount rate | Terminal growth | Illustrative value |
|---|---|---|---|
| Base case | 22 per cent | 2 per cent | $1,000,000 |
| Discount rate 2 points higher | 24 per cent | 2 per cent | $900,000 |
| Discount rate 2 points lower | 20 per cent | 2 per cent | $1,120,000 |
| Terminal growth 1 point higher | 22 per cent | 3 per cent | $1,050,000 |
The figures are assumed to illustrate the direction and rough scale of the effect, not to describe any real business. The lesson is that a DCF conclusion should be presented with the range that reasonable assumptions produce, and the report should explain why the chosen point within that range is the right one.
When a DCF suits a small business, and when capitalising earnings is better
A DCF is the better tool when the future is expected to look different from the past and that difference can be evidenced. Examples include a business with a signed contract that will step revenue up next year, a business with a defined life, a start-up with a funded plan and early trading data, a project-based business whose cash flows are lumpy, and a business investing heavily now for returns later. It can also help a loss-making business with a credible path to profit.
Capitalising maintainable earnings is usually better for an established business with a stable or steadily growing record. It uses evidence that exists, it is easier for a reader to check, and it avoids presenting a forecast the owner cannot support. Where a valuer uses a DCF for a stable business, it should be as a cross-check against the primary method, and the two results should be reconciled.
How a reviewer tests a DCF
A reviewer, whether a buyer's adviser, a tax adviser or an expert engaged by the other side, will start by comparing the first forecast year with actual trading to date. A forecast that begins with a jump the business has never achieved will be questioned immediately. They will then look at whether margins, working capital and capital expenditure move consistently with the assumed growth, because growth that needs no investment is a warning sign.
They will test the discount rate build-up against the specific risks described elsewhere in the report, check that the terminal growth assumption is consistent with long-run economic growth, and ask what proportion of the value sits in the terminal period. Finally, they will cross-check the implied multiple of current earnings against transaction evidence. If the DCF implies a multiple far above what comparable businesses have sold for, the report needs to explain why.
What to prepare if a DCF is the right method
Prepare a forecast you are willing to defend, with the reasoning behind each line: signed contracts, pipeline data, pricing decisions, hiring plans and the capital spending required. Provide at least two years of historical accounts so the starting point can be verified, and identify any assumption you consider uncertain rather than leaving a reviewer to find it.
Tell us who will rely on the report and for what purpose, because that shapes how much sensitivity analysis is needed. Valuation Group works with businesses across Australia by phone, video and secure document exchange, and the first conversation is free. Contact Jackson Wilson to discuss whether a DCF, a capitalisation of earnings valuation or a combination suits your situation, or read how we scope a business valuation.
Apply it to your matter
A clear scope is the next step.
Discuss the business, purpose, valuation date and intended user with Jackson Wilson. Valuation Group is based in Double Bay and takes enquiries from Sydney and Australia-wide.
General educational information. Examples are hypothetical and do not value a real business. The appropriate treatment depends on the purpose, evidence and agreed scope.