The short answer, explained
A discounted cash flow (DCF) valuation forecasts the cash a business will generate, then converts those future amounts into a value today using a discount rate that reflects time and risk. It is a standard method: ASIC's guidance on expert reports lists it among the methodologies an expert should generally consider, and the ATO's guide on market valuation for tax purposes names it, alongside capitalisation of earnings, as a method within the income approach.
The method is not the problem. The inputs are. Because a DCF values cash that has not yet been earned, its credibility depends on whether there are reasonable grounds for the forecast and whether the discount rate can be explained. For the mechanics of building a DCF, Oliver Group, the Valuo practice for restructures, tax and buyouts, explains the parts in when discounted cash flow is the right valuation method. This page asks a different question: when should anyone rely on the answer?
A DCF is credible only when the forecast has reasonable grounds
Is there evidence the forecast cash flows will happen?
Yes: contracts, history, a tested forecaster and an explained rate
A DCF can carry real weight, with a sensitivity table and a cross-check.
Partly: some drivers evidenced, others hoped for
Use the DCF with caution: risk-weight or trim the unsupported growth, and lean on a second method.
No: growth rests on plans or the owner's expectations
Other methods should carry the weight. RG 111.116 says other methodologies should be used where an expert lacks reasonable grounds for the forecast.
What "reasonable grounds" looks like
ASIC's Regulatory Guide 111 is written for expert reports in regulated transactions, but its tests are a useful benchmark for any DCF. It says an expert should not include forecasts or other forward-looking information unless there are reasonable grounds for it, should make enough inquiries to be satisfied the forecasts were prepared on a reasonable basis, and should critically analyse the forward-looking information used in a DCF. Where an expert does not have reasonable grounds, other methods should be used. It also expects the report to disclose the material assumptions, the discount rate and the reason for it, and the period the forecast covers.
Financial reporting offers a second reference point. For an impairment test of value in use (a different purpose from market value), AASB 136 requires cash flow projections based on reasonable and supportable assumptions, caps budget-based projections at five years unless a longer period can be justified, and expects management to check its assumptions by examining differences between past forecasts and actual results. That last test is one of the most practical ways to judge a private company forecast.
Decision table: is a DCF credible here?
| Condition | Points towards a credible DCF | Points away from a DCF |
|---|---|---|
| Evidence for revenue | Signed contracts, recurring customers, a documented pipeline with conversion history | Growth based on plans, new products not yet sold, or the owner's expectations |
| Forecasting track record | Past budgets compared with actual results, and differences explained | No past forecasts, or forecasts prepared only for this valuation |
| Change from the past | Known changes that history does not capture (a new contract, a finished expansion, a lease ending) | No clear reason the future will differ from recent results, so a capitalised earnings method may be simpler and equally informative |
| Cost and capital detail | Wages, margins, capital spending and working capital forecast and tied to capacity | Revenue forecast in detail but costs and funding assumed to scale smoothly |
| Discount rate | Built from a stated risk-free reference plus explained allowances for risk | A single rate with no derivation, or one chosen to reach a figure |
| Where the value sits | A meaningful share of value comes from the forecast years | Almost all value sits in the terminal value, after the forecast ends |
| Cross-check | A second method gives a broadly consistent answer, or the difference is explained | No cross-check, or a large unexplained gap |
The ATO recommends that, where possible, a secondary or cross-check method support the primary method, and it lists "lack of support for size, risk and other adjustments to the chosen discount rate" among the issues it commonly sees.
Worked example: how sensitive is a DCF?
This example is hypothetical. The cash flow, discount rates and growth rates are assumptions chosen for the arithmetic. They are not recommendations, market evidence or a view about any industry.
To isolate the effect of the two key rates, use the simplest form of DCF: cash flow expected next year, growing at a constant rate forever. The value today is next year's cash flow divided by the difference between the discount rate and the growth rate.
Assume next year's free cash flow is $126,000.
| Discount rate (assumption) | Growth 2% (assumption) | Growth 4% (assumption) |
|---|---|---|
| 18% | $126,000 / 0.16 = $787,500 | $126,000 / 0.14 = $900,000 |
| 20% | $126,000 / 0.18 = $700,000 | $126,000 / 0.16 = $787,500 |
| 22% | $126,000 / 0.20 = $630,000 | $126,000 / 0.18 = $700,000 |
Take 20% and 2% as the base case: $700,000. Lowering the discount rate by 2 percentage points to 18% raises the value by $87,500 (12.5%); raising it to 22% lowers it by $70,000 (10%); raising growth from 2% to 4% raises it by $87,500 (12.5%). The two optimistic changes together compound:
Two modest-looking changes lift the value from $700,000 to $900,000
- Base case (20% discount rate, 2% growth)$700,000
- Discount rate 20% to 18%+$87,500
- Growth 2% to 4%, at 18%+$112,500
- Optimistic case (18%, 4%)$900,000
Scale starts above zero so the changes are visible. Totals are cut short.
Check: $787,500 - $700,000 = $87,500; $900,000 - $787,500 = $112,500; $87,500 / $700,000 = 12.5%; $70,000 / $700,000 = 10%; $200,000 / $700,000 is 28.6%.
A full DCF has several forecast years before a terminal value, but the same arithmetic drives the terminal value, which often carries much of the total. The lesson holds: modest-looking changes to growth or the discount rate can move the answer by more than 10%, so each needs evidence. The formula only works when growth is below the discount rate, and the long-term growth rate should not exceed what the economy can sustain over the long run. The final-year cash flow should also already allow for the capital spending and working capital needed to deliver that growth; growing a cash flow that leaves out reinvestment overstates value. You can explore the same kind of sensitivity on a capitalised earnings basis with the capitalised earnings sensitivity tool.
Building a discount rate you can explain
A discount rate for a private business is usually built in layers: a risk-free reference, plus allowances for the risk of equity investment generally and for the risks of this business. The Reserve Bank publishes Commonwealth government bond yields in its statistical table F2, a common starting point for the risk-free layer. The other layers involve judgement, and RG 111 expects the rate and its rationale to be disclosed.
Two consistency points matter as much as the level of the rate. The cash flows and the rate must be on the same basis (for example, both before or both after tax, both nominal or both real). And a risk should be reflected once: if a forecast has already been reduced for a risk, such as a customer likely to leave, the discount rate should not be raised for the same risk. Our guide to customer concentration discusses this choice.
Limitations
- The worked example uses a constant-growth formula to show sensitivity. It is not a complete DCF and should not be used to value a business.
- RG 111 applies to expert reports in transactions regulated under the Corporations Act, and AASB 136 to financial reporting. They are cited here as references for good practice, not as rules that govern every private valuation.
- A credible DCF still produces an opinion of value, not a price. What a buyer pays depends on negotiation and terms.
- For start-ups without revenue history, the question of reasonable grounds is harder, and other methods or cross-checks usually carry more weight. See valuing a business with negative or volatile earnings.
Next steps
- Ask your adviser for the forecast assumptions in writing: revenue drivers, margins, wages, capital spending and working capital.
- Put your last two or three budgets beside the actual results and explain the differences.
- Ask how the discount rate was built, layer by layer, and what evidence supports each layer.
- Ask for a cross-check using another method, and for a sensitivity table showing the value at different growth and discount rates.
Questions
Is a DCF better than a multiple of earnings?
Neither is better in general. Both are income approach methods. A DCF suits a business whose future cash flows will differ from its past in ways that can be evidenced; a capitalised earnings method suits a business whose recent earnings are a fair guide to the future.
What discount rate should be used for a small business?
There is no standard rate. The rate should be built from a risk-free reference, such as government bond yields, plus allowances for the risks of this business, with each step explained. The rates on this page are assumptions for the example only.
My forecast shows strong growth. Will a valuer use it?
A valuer will test it. Expect questions about contracts, pipeline, capacity, the cash needed to fund the growth and how past forecasts compared with results. Growth that cannot be supported is usually reduced, risk-weighted or reflected in a higher discount rate.
How long should the forecast period be?
Long enough to reach a stable state, and no longer than the evidence supports. For financial reporting value-in-use tests, AASB 136 caps budget-based projections at five years unless a longer period can be justified, which is a useful discipline to compare against.
Sources
- RG 111 Content of expert reports (issued 22 October 2020), Australian Securities and Investments Commission. RG 111.86 lists DCF among appropriate methods; RG 111.91 to 111.94 on reasonable, disclosed assumptions and sensitivity analysis; RG 111.112 to 111.117 on reasonable grounds for forward-looking information and DCF disclosure.
- Market valuation for tax purposes, Australian Taxation Office (Legal Database). Guide current at February 2025: DCF and capitalisation of earnings are income approach methods; a cross-check method is recommended; common issues include unsupported discount rate adjustments and unreasonable assumptions.
- AASB 136 Impairment of Assets (Compilation No. 5, 30 June 2026), Australian Accounting Standards Board (Federal Register of Legislation). Paragraphs 33 and 34: for value in use, projections on reasonable and supportable assumptions, no more than five years of budgets unless a longer period can be justified, and assumptions checked against past forecasts.
- Statistical tables: Capital Market Yields, Government Bonds, Daily (F2), Reserve Bank of Australia. Where Commonwealth government bond yields, a common risk-free reference point, are published.
Cite or reuse this page
Valuo Insights team (2026). When is a DCF valuation credible for a private business?. Valuo. https://valuo.com.au/insights/when-is-a-dcf-valuation-credible/ (updated 14 November 2026).
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General educational information, not financial, tax or legal advice. Worked examples are hypothetical and do not value a real business. A valuation depends on its purpose, the evidence and the agreed scope.