Discounted cash flow (DCF) valuation
A discounted cash flow valuation forecasts a business’s free cash flows over three to five years, adds a terminal value, and discounts the total to present value at a risk-adjusted rate.
It is the right method when history is a poor guide to the future — a business scaling quickly, one that has just won or lost a major contract, or a project with a finite life. It is also the most assumption-sensitive method, which is why every DCF we prepare is presented with sensitivities.
Step by step
How a DCF valuation is built
The arithmetic is straightforward. The work is in making each assumption defensible, because small changes compound into large differences.
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01
Build and test the forecast
Three to five years of revenue, margin, working capital and capital expenditure. We test the forecast against historical performance and industry evidence rather than accepting management numbers at face value.
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02
Convert to free cash flow
Earnings adjusted for tax, the working capital the growth actually consumes, and the capital expenditure required to sustain the asset base. Growth that consumes more cash than it generates reduces value, not increases it.
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03
Set the discount rate
A weighted average cost of capital reflecting the cost of debt, the cost of equity and a specific-risk premium for a private company of this size. The build-up is shown component by component.
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04
Terminal value and sensitivities
A terminal value on a perpetuity growth or exit multiple basis, then sensitivity tables across the discount rate and growth assumptions so the reader can see the range, not just a point.
Honest scope
When this method fits — and when it does not
Use it when
- Earnings are growing or changing materially year on year
- A major contract has just started or ended
- The business has a finite life — a project, licence or lease term
- You are raising capital and investors expect a modelled view
Look elsewhere when
- There is no credible basis for a multi-year forecast
- The business is small, stable and better served by a multiple
- Records are too thin to test the forecast against history
- The purpose requires a simple, quickly reviewable conclusion
Worked example: a managed services business
The business signed two three-year managed services contracts last year, taking recurring revenue from 30 to 65 per cent of the total. Historical earnings badly understate the current run rate, so capitalising a three-year average would materially undervalue it.
A five-year forecast is built off the contracted base, with churn and margin tested against the last two years. Free cash flow is discounted at a WACC of 14.5 per cent, with a terminal value on a 3.0× exit multiple, and sensitivities run at 13 to 16 per cent.
A defensible range rather than a single point — and the range is the deliverable
Illustrative only. Every engagement is scoped to the specific business, its records and the purpose of the valuation.
What we need
Inputs for this valuation
A DCF needs everything a capitalisation valuation needs, plus a forward view we can test. The forecast does not need to be polished; it needs to be honest.
Open the document checklist →- Financial statements — three years To test the forecast against actual performance
- Forecast or budget Three to five years, with the assumptions behind it
- Contract schedule Terms, values, expiry dates and renewal rights
- Capital expenditure plan What must be spent to sustain and to grow
- Working capital history Debtor days, creditor days and stock turns
- Debt and facility terms Rates, covenants and repayment profiles
Because it represents every cash flow after the forecast period, which is most of a going concern’s life. In typical SME models it accounts for more than half the total value — which is exactly why the growth rate and exit multiple behind it are the assumptions we test hardest and disclose most fully.
It is built, not chosen: a cost of equity from a risk-free rate plus equity risk premium plus a size and specific-risk premium, blended with the cost of debt at the business’s actual capital structure. For Australian SMEs the result commonly lands between 12 and 20 per cent, and the build-up is shown in full.
Only if it is undisclosed. We test forecasts against historical performance and industry evidence, and where a forecast is ambitious we either adjust it or run it as an upside sensitivity alongside a base case. A valuation built on an untested forecast is the first thing an opposing expert dismantles.
Yes, where the forecast is reasonable, the discount rate build-up is documented and the assumptions are disclosed. DCF is standard practice for early-stage and high-growth valuations, including for employee share scheme purposes.
Yes. A DCF is cross-checked against a capitalisation of earnings result and, where data exists, market comparables. If the methods diverge materially, that variance is explained in the report rather than quietly averaged away.
Reviewed by a Certified Practising Valuer
Reviewed by Jarrad Khoury, Director and Head of Valuations — Registered Valuer (QLD, Not Limited), Licensed Valuer (WA, Not Limited), CPV and CBV. Published by Business Valuations Brisbane, the business valuation division of Asset Valuations Group.
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