Financial

DCF (Discounted Cash Flow)

A valuation method that estimates the present value of a business by projecting future cash flows and discounting them back to today using a risk-adjusted discount rate.

Key Insight

DCF is theoretically correct and practically unreliable for small businesses. The inputs — growth rate, discount rate, terminal value — are speculative enough that the output is often garbage dressed up in math.

How DCF Works

  1. Project free cash flows: Forecast the business's FCF for 5-10 years
  2. Determine discount rate: Apply a risk-adjusted rate (WACC or required return) to account for time value of money and business risk
  3. Calculate terminal value: Estimate the value of all cash flows beyond the projection period (usually as a perpetuity or exit multiple)
  4. Discount to present value: Sum all projected FCFs and terminal value, discounted at the discount rate

Why DCF Is Rarely Used for SMB Acquisitions

For large, publicly traded companies or PE-backed businesses with professional finance functions, DCF is a reasonable tool. For SMBs under $5M in revenue:

  • Cash flow forecasting is speculative: A 3-year-old HVAC company with $280K SDE doesn't have the data to reliably project 10-year cash flows
  • Discount rate is arbitrary: SMB discount rates should reflect illiquidity, small-company risk, and single-operator risk — but quantifying these is more art than science
  • Terminal value dominates: In most DCF models, 60-80% of the value is in the terminal value, which is just a multiple applied to a projected number

In practice: SMB acquisitions are priced primarily on SDE or EBITDA multiples derived from comparable transactions — what similar businesses actually sold for.

When DCF Is Useful

DCF is useful as a sanity check: if a multiple-based valuation produces a price that implies a 3% annual return on a DCF basis, that's a signal something is wrong with the multiple or the earnings estimate.

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