Insights & Info

Insights > What is the Discounted Cash Flow Valuation Method?

What is the Discounted Cash Flow Valuation Method?

By Generational Equity

discounted cash flow valuation

One of the most interesting concepts that we introduce to business owners at our M&A seminars is the discounted cash flow method of business valuations. Quite a few attendees are aware of the most common method of how to value their businesses – a multiple of the most recent fiscal year earnings – because lots of industries have a “rule of thumb” that uses this method.

For example, if you look at the Business Reference Guide published by the Business Brokerage Press you will see page after page of industry valuation “rules of thumb.” For example, if you look up “Auto Tire Stores,” you will see a standard rule of thumb indicating that these operations go for 1.5 to 2.75 times recast earnings plus inventory (for a definition of recasting, please follow this link). Lawn maintenance businesses go for 1.5 to 2 times recast earnings plus inventory. Publishers of newsletters typically have a rule of thumb of 1 to 2 times revenue. And so forth.

Your industry probably has some variation of this as well. These rules of thumb by and large are fairly accurate in terms of historically giving a value range for a business in a specific industry. However, it is only one valuation method, and it does not account for two things:

  1. Any unique features of your company that may command a premium (or conversely any negative issues it faces that may require a discount)
  2. The future cash flow your company will generate

And it is this last issue that the discounted cash flow (DCF) method addresses. Of all the concepts we introduce at our seminars, the DCF is probably the most challenging for business owners, especially those without degrees in finance, to understand. So as we do in our seminars, we are going to present a simplified explanation of this method of valuation. Here is the official definition of DCF:

"In finance, discounted cash flow (DCF) analysis is a method of valuing a project, company, or asset using the concepts of the time value of money. All future cash flows are estimated and discounted to give their present values (PVs)—the sum of all future cash flows, both incoming and outgoing, is the net present value (NPV), which is taken as the value or price of the cash flows in question."

For those of you that love the mathematics, here is the DCF formula for your pleasure:

"The discounted cash flow formula is derived from the future value formula for calculating the time value of money and compounding returns.

Thus the discounted present value (for one cash flow in one future period) is expressed as:


  • DPV is the discounted present value of the future cash flow (FV), or FV adjusted for the delay in receipt;

  • FV is the nominal value of a cash flow amount in a future period;

  • r is the interest rate or discount rate, which reflects the cost of tying up capital and may also allow for the risk that the payment may not be received in full;

  • n is the time in years before the future cash flow occurs."

For those of us that are not mathematicians, what does all this mean in laymen’s terms? Essentially this: The DCF model is used by professional buyers to determine what they will pay today for the future earnings of your company. The model works this way: Your historical income statement is recast to reflect the true earnings of the company. Once this process is completed, a “base year” is forecast. This is usually the current fiscal year that you are in.

Once the base year number is established, you will then need to create what accountants call a pro forma financial statement. This is a fancy term for the building of five years of income statements, which ultimately show your recast earnings from year one of the pro forma through year five.

With me so far? This is where it gets complicated. At this point you are ready to discount the future earnings back to today’s dollars. The critical issue is the rate you will be using to discount your earnings. The discount rate is critical because the lower the discount rate, the higher your business valuation will be. Conversely, the higher the discount rate, the lower it will be. So determining what discount rate to use is vital, and the discount rate is determined by the perceived risk associated with the investment.

The Discount Rate is Key

This is an inexact science. A risk-free investment, say a government bond, would command a very low discount rate to value. An investment in a publically held company, although riskier, is not as risky as an investment in a privately held company. In addition, your particular company may have risk factors associated with it that could impact your discount rate. Other factors that could also impact it are your historic growth rate vs. your forecasted rate. For example, if your company has been growing at a 5% rate and you are forecasting five years of growth at 25%, it is almost guaranteed that a buyer will apply a higher discount rate.

This is why, as we have stated before, it is really vital that you have professional M&A advice before approaching buyers. Certainly the DCF valuation model is not the only valuation method that buyers will use to value your business. Savvy buyers will apply several methods to accurately value your company so that they can earn the ROI (return on investment) that they need. However, they will ultimately use the method that gives them the greatest return, which means your valuation may be lower. Again, if you have a professional M&A advisor working with you, the value of your company will be determined before you go to market using the DCF and other financial models. This allows you to have an idea of the value range you should expect buyers to be in.

Of course I have over simplified the DCF process. The reality is that the method can be very complicated, as all valuation methods can become. A tremendous number of variables need to be accounted for that I cannot cover in 1,000 words or less. If you are interested in seeing the DCF model in action, as well as getting an overview of other methods used, attend a Generational Equity M&A seminar in your area. The information we provide is helpful as you begin your exit planning. To find out more, please visit our website.

Carl Doerksen is the Director of Corporate Development at Generational Equity.

© 2015 Generational Equity, LLC. All Rights Reserved.

Make an informed decision

The best decisions in life are informed decisions. We release educational business insights like this every week. Subscribe to make sure you don’t miss the latest news, views and analysis.


Success, you have been added to our list.

Thank you again for all your guidance and support. Any company will achieve what they intend, if they have you on their team!
Rick Nowak, President/CEO, Kurz Electric Solutions, Inc.
I wanted to write you a quick letter to express our appreciation and our delight on the outcome of helping us through the process of our recent sale. We are very happy with the end result, and are very happy to be able to move forward with all of our future growth plans.
Terry D. Wickman, President, Keytroller
Generational Equity’s assistance was invaluable in compiling and marketing our business.
Bil MacLeslie, CEO, ipHouse
I need to say an immense thank you to Don Ho for his stellar work ethic, attention to detail, and tireless effort. Also thank you to the whole crew at GE! Without you, Don could not do such a phenomenal job. We were shooting for closing and funding before the end of 2020, due to the uncertainty of the political landscape and taxes. I am happy to report we closed last week and will be funding tomorrow.
Dr. Caty J. Catron PhD, RN, VA-BC – Owner, Vic The Picc, LLC
Bruce and I wanted to take this opportunity to thank Generational Equity for assigning Musa Jagne to our transaction. In Bruce’s words, “Musa did one hell of a job for us!”
Karen S. Williams, CFO, BW Manufacturing
I am pleased that I was able to work with Andrew Byrd throughout this experience. From the first meeting we had in Minneapolis I felt that I was in good hands. His knowledge and expertise is second to none. He guided the process consistently throughout. I feel lucky that I was pared with Andrew and could not be happier that I chose Generational Equity to handle this major life event. Thank you Andrew and GenEq for everything!
Eric Erlandson, Owner, Action Fastenings, Inc.
We are extremely pleased with the way Generational Equity handled the sale of our company. Your associates, Tom and Chris, did an outstanding job of getting us (me) through the process.
Michael J Polarek, President, Paragon Packaging
The process was much more involved than I expected and your help, experience and advice was a big factor in making the negotiations go as smoothly as possible.
Terry D. Wickman, President, Keytroller
I must say that I have never worked with a more driven, competent and focused individual as Don Ho.
Jay Dinnison, Owner of Sharpe Mixers
We thank you Eric and Generational Equity making our dream come true.
Larry Moore, Owner, A Company Portable Restrooms
Your wisdom and experience were invaluable to me during this once-in-a-lifetime transaction.
Ralph Noblin, President of Noblin & Associates
We will highly recommend Generational Equity and Musa Jagne to any business owner about to embark on the same process.
Karen S. Williams, CFO, BW Manufacturing
I couldn’t have asked for a better team than Michael and Deborah. We couldn’t have done it without them.
Robert Evans, President and CEO of Mealtracker Dietary Software
We are very happy with the end result, and are very happy to be able to move forward with all of our future growth plans.
Rick Nowak, President/CEO, Kurz Electric Solutions, Inc.
We were happy to see the interest in our company and what we cherished has not just a valuable company but an important company to the communities we served in.
Larry Moore, Owner, A Company Portable Restrooms
Dear Chris and Andre, I just wanted to say thanks for all your help. Even though this process was not an easy one, it was comforting to know that I had a capable team standing beside me. You made me feel like we were almost your only client or at least the most important one. Thanks again, and I will recommend your service in the future.
Shenille Engelhart, Owner – CLS Technology
Thanks again Phil and feel free to have a future client call me if they would like a referral. You are a true professional!
Andy Graham, Vice President, Modern Heating & Plumbing
T.D., thank you so much! You are a great leader! I love how you are using your gifts and talents to better others. You are clearly a GREAT COACH! This 3 day session undoubtedly changed the future of our business, and very well may have been the sole catalyst to save my company, my health and my marriage! A genuine “thank you” from the bottom of my heart.
Bryan D. Horn, Owner, Over Under Clothing
Generational Equity educated and informed us – so that we could be on the upside of a good decision (to sell).
Bil MacLeslie, CEO, ipHouse
The help you provided us during each step of this process made us feel very comfortable and confident we were selecting the right approach to transition our Company.
Andy Graham, Vice President, Modern Heating & Plumbing
Tom Staszak is one of the most professional people I have dealt with in my last forty years of business. You’ve got a great group of people and you have built a truly professional organization.
Michael J Polarek, President, Paragon Packaging
Michael worked tirelessly, He followed every lead meticulously and urgently to make sure nothing was missed.
Robert Evans, President and CEO of Mealtracker Dietary Software
Greetings Mike. Thank you for the captivating and compelling presentation you made at the Phoenix presentation last week. Over many years in business yours was the most informative and well-presented presentation, on any subject, that I have ever attended! Your energy and enthusiasm combined with your concise and captivating support of your positions with easily understood examples and data was compelling.
Pete L.
I would like to thank you and your firm, Generational Equity, for being our valued advisors in our journey.
Bil MacLeslie, CEO, ipHouse
We knew it would be a difficult task to have someone really understand our business and our market, prior to researching a possible buyer, so it was imperative that we found someone of your caliber, with definite proven experience in this area.
Rick Nowak, President/CEO, Kurz Electric Solutions, Inc.
I quickly recognized that Don was working for Sharpe Mixers above all else, and held our interests above others.
Jay Dinnison, Owner of Sharpe Mixers