Discounted Cash Flow Business Valuation: Formula, Method, and Examples

By Joey N. Friedman, CPA, ABV, MAcc, MIB — President, Joey Friedman CPA PA. This article is published by Joey Friedman CPA PA, a Florida professional association. All forensic accounting, business valuation, expert witness, and litigation support services described herein are provided by Joey Friedman CPA PA. Mr. Friedman’s professional credentials and experience are exercised in his capacity as an officer, agent, and licensed CPA practicing under and on behalf of Joey Friedman CPA PA.

Quick Answer

DCF discounted cash flow business valuation formula and method
Discounted Cash Flow Business Valuation: Formula, Method, and Examples 1

Discounted cash flow (DCF) is the income-approach valuation method that projects a business’s future free cash flows for an explicit period (typically 5-10 years), adds a terminal value, and discounts everything back to present value using a risk-adjusted discount rate. The DCF formula is: Value = Σ [FCFₜ ÷ (1+r)ᵗ] + [Terminal Value ÷ (1+r)ⁿ], where FCF is free cash flow in year t, r is the discount rate, and n is the final explicit year. DCF is conceptually the purest valuation method because it directly links value to the economic substance of the business — its capacity to generate cash. In litigation valuations, DCF survives cross-examination when each input (revenue projection, expense projection, capital expenditure assumption, discount rate, growth rate, terminal value) is documented and defensible. DCF fits multi-stage growth profiles, businesses with reliable projections, and situations where the market approach lacks adequate comparable data.

DCF is one of the six core business valuation methods. This article explains the formula, walks through the calculation, identifies when DCF applies vs. when other methods fit better, and explains what makes a DCF analysis defensible under Daubert-level scrutiny.

The DCF Formula

The DCF formula:

Value = Σ [FCFₜ ÷ (1+r)ᵗ] + [Terminal Value ÷ (1+r)ⁿ]

Where:

  • FCFₜ = Free cash flow in year t
  • r = Discount rate (typically the weighted average cost of capital — WACC)
  • t = Year number (1, 2, 3, … n)
  • n = Final year of explicit projection period
  • Terminal Value = Value of all cash flows beyond year n, expressed as a lump sum at year n

The formula sums the present value of every projected year’s cash flow plus the present value of the terminal value. The result is enterprise value (operating value of the business).

The Six Steps of DCF

Step 1: Project Future Revenue

Revenue projection year-by-year for the explicit projection period. Sources:

  • Historical trend (3-5 years of actuals)
  • Management projections (validated against historicals)
  • Industry growth forecasts
  • Customer pipeline and backlog
  • Capacity constraints

For closely-held businesses, management projections frequently exceed historical achievement. The analyst must apply professional skepticism — and document the basis for the projection.

Step 2: Project Operating Expenses and EBITDA

Year-by-year operating expenses. Margins typically track historical patterns unless something material changes. The result: projected EBITDA for each year.

Step 3: Derive Free Cash Flow

Starting from EBITDA, calculate free cash flow to the firm (FCFF):

  • EBITDA
  • − Depreciation × Tax rate (to derive after-tax adjustment)
  • − Cash taxes on operating income
  • − Capital expenditures (CapEx)
  • − Change in working capital
  • = Free cash flow to the firm (FCFF)

For closely-held businesses, getting CapEx and working capital right is often the difference between a defensible DCF and a flawed one. Many DCFs significantly understate CapEx (using book depreciation as a proxy when real CapEx requirements are higher).

Step 4: Calculate the Terminal Value

The terminal value captures all cash flows beyond the explicit projection period. Two common approaches:

Gordon growth model:

Terminal Value = FCFFₙ₊₁ ÷ (r − g)

Where g = perpetual growth rate (typically 2-3% for mature businesses).

Exit multiple method:

Terminal Value = EBITDAₙ × Industry EV/EBITDA multiple

(Using projected year-n EBITDA and an industry-appropriate multiple. See EV/EBITDA.)

Many analysts use both and reconcile.

Step 5: Calculate the Discount Rate

The discount rate represents the risk-adjusted return a buyer would require. For a closely-held business valuation, the discount rate is typically the weighted average cost of capital (WACC):

WACC = (E/V) × Re + (D/V) × Rd × (1 − Tax rate)

Where:

  • E = market value of equity
  • D = market value of debt
  • V = total capital (E + D)
  • Re = cost of equity (typically from CAPM: risk-free rate + beta × equity risk premium + size premium + specific company risk premium)
  • Rd = cost of debt (typically yield on comparable corporate debt)
  • Tax rate = effective tax rate

For closely-held businesses, WACC typically runs 15-25%. The cost of equity is the dominant component; small businesses bear higher size and specific-risk premiums than public companies.

Step 6: Discount Cash Flows Back to Present Value

Discount each year’s FCFF and the terminal value back to year 0 using the discount rate.

Example with year-1 FCFF = $1,000,000, discount rate = 20%:

PV = $1,000,000 ÷ (1.20)¹ = $833,333

Year-2 FCFF = $1,100,000, same discount rate:

PV = $1,100,000 ÷ (1.20)² = $763,889

Sum the present values to reach enterprise value.

A Numerical Example

Consider a closely-held services business with:

  • Year 1 FCFF: $800,000
  • Year 2 FCFF: $880,000 (10% growth)
  • Year 3 FCFF: $950,000 (~8% growth)
  • Year 4 FCFF: $1,020,000 (~7%)
  • Year 5 FCFF: $1,090,000 (~7%)
  • Year 6 FCFF (for terminal): $1,134,000 (~4%)
  • Discount rate: 18%
  • Long-term growth rate: 3%

Terminal value (year 5, Gordon growth):

TV = $1,134,000 ÷ (0.18 − 0.03) = $7,560,000

Discount factors at 18%:

  • Year 1: 1.18 → 0.8475
  • Year 2: 1.39 → 0.7182
  • Year 3: 1.64 → 0.6086
  • Year 4: 1.94 → 0.5158
  • Year 5: 2.29 → 0.4371

Present values:

  • Year 1: $800K × 0.8475 = $678,000
  • Year 2: $880K × 0.7182 = $632,016
  • Year 3: $950K × 0.6086 = $578,170
  • Year 4: $1,020K × 0.5158 = $526,116
  • Year 5: $1,090K × 0.4371 = $476,439
  • Terminal: $7,560K × 0.4371 = $3,304,476
  • Sum: $6,195,217 enterprise value

This conceptual exercise illustrates the calculation. In real valuation work, each input requires documentation, sensitivity analysis around key inputs (especially discount rate and growth rate), and reconciliation with other valuation approaches.

When DCF Applies

DCF fits when:

  • The business has predictable, projectable cash flows
  • Management projections are available AND defensible
  • The growth trajectory is multi-stage (not constant growth)
  • Market comparables are limited or unreliable
  • The matter requires a thorough income-approach analysis
  • Litigation valuations where opposing counsel will probe each assumption — DCF’s explicit-year transparency makes the analysis testable

When DCF Doesn’t Fit

DCF is less appropriate when:

  • Cash flows are too volatile or unpredictable to project credibly
  • Management projections are absent or clearly biased
  • The business is in early stage with little operating history
  • Capitalization of earnings handles the situation more cleanly (stable mature businesses)
  • The matter doesn’t require the explicit-year detail DCF provides

In these cases, capitalization of earnings or pure market-approach methods (see 6 key BV approaches) may produce more defensible conclusions.

What Makes a DCF Defensible

For litigation valuations, DCF must survive Daubert-level scrutiny. Defensible documentation includes:

Revenue projection support. Historical revenue trends, customer pipeline data, industry forecasts, capacity analysis. Why the projected growth rate is defensible.

Margin projection support. Historical margin patterns, expected changes (cost inflation, productivity), benchmark comparisons.

CapEx projection support. Multi-year history of capital expenditures, replacement cycle, growth requirements.

Working capital projection support. Days sales outstanding, days inventory, days payable trends; how each scales with revenue.

Discount rate derivation. Each WACC input (cost of equity, cost of debt, capital structure, size premium, specific company risk premium) documented with empirical support.

Terminal value support. The long-term growth rate or exit multiple, with industry support.

Sensitivity analysis. Value under alternative discount rates, growth rates, and capex assumptions. Shows how sensitive the conclusion is to each input.

Reconciliation with other methods. The DCF conclusion should reconcile reasonably with capitalization of earnings and market-approach methods. Material divergence requires explanation.

This documentation discipline is what lets the DCF opinion survive cross-examination. See Daubert-ready CPA expert witness checklist for the broader framework.

Common DCF Errors

Frequent errors that compromise DCF outcomes:

Aggressive growth assumptions. Projected growth substantially above historical without supporting basis. Easy to attack on cross-examination.

Insufficient CapEx. Treating book depreciation as a proxy for CapEx when real CapEx exceeds it. Underestimates capital intensity, overstates value.

Optimistic terminal value. Terminal value typically represents 50-70% of total DCF value. Aggressive long-term growth assumptions inflate this disproportionately.

Discount rate too low. Using public-company beta without adjusting for size and specific risk understates the discount rate, overstates value.

Working capital ignored. Revenue growth requires working-capital investment. DCF that omits this overstates cash flow.

Multi-stage growth oversimplified. Treating the explicit period as constant growth when the business is multi-stage produces a mismatch.

Tax treatment errors. Mixing pre-tax and after-tax cash flows; using wrong tax rate (statutory vs effective).

DCF vs Capitalization of Earnings

DCF and capitalization of earnings are both income-approach methods. The choice between them:

Aspect DCF Capitalization
Growth profile Multi-stage Constant growth
Projection horizon 5-10 years explicit + terminal Single normalized year
Best fit Growth-phase, businesses with defensible projections Mature, stable businesses
Complexity Higher — many inputs to defend Lower — one earnings figure + cap rate
Documentation burden Higher Lower
Litigation use Common where projections are defensible Common where projections aren’t

For closely-held business valuations, capitalization of normalized earnings is often the workhorse income-approach method. DCF is reserved for situations where the projection support genuinely exists. See 6 key BV methods for the broader comparison.

Frequently Asked Questions

What is the DCF method in business valuation?

DCF (discounted cash flow) projects a business’s future cash flows for an explicit period (5-10 years), adds a terminal value, and discounts everything back to present value using a risk-adjusted discount rate. The result is enterprise value. DCF is one of two core income-approach methods (the other being capitalization of earnings).

What’s the DCF formula?

Value = Σ [FCFₜ ÷ (1+r)ᵗ] + [Terminal Value ÷ (1+r)ⁿ]. Where FCF is free cash flow in year t, r is the discount rate, and n is the final year of the explicit projection.

How is the discount rate calculated?

For closely-held businesses, the discount rate is typically the weighted average cost of capital (WACC), built from cost of equity and cost of debt weighted by capital structure. Cost of equity is typically calculated using the capital asset pricing model (CAPM): risk-free rate + beta × equity risk premium + size premium + specific company risk premium. WACC for closely-held businesses typically runs 15-25%.

What is terminal value in DCF?

Terminal value is the present value of all cash flows beyond the explicit projection period, expressed as a lump sum at the end of the projection. Two common methods: Gordon growth model (FCFFₙ₊₁ ÷ (r − g)) or exit multiple (EBITDAₙ × industry EV/EBITDA multiple). Terminal value typically represents 50-70% of total DCF value.

When is DCF the right valuation method?

DCF fits when the business has predictable, projectable cash flows, when management projections are available and defensible, when growth is multi-stage rather than constant, and when market comparables are limited. For mature businesses with stable growth, capitalization of earnings is often a cleaner alternative. For early-stage or volatile businesses with weak projections, market or asset approaches may produce more defensible conclusions.

Why does DCF produce different values from market multiples?

DCF directly values the business’s specific cash flow profile and risk. Market multiples value the business by comparing to similar transactions/companies. Both should produce comparable conclusions if the inputs and comparables are appropriate. Material divergence between methods usually indicates either flawed comparables (market) or aggressive projections (DCF) and requires investigation.

How sensitive is DCF to inputs?

Very sensitive. Small changes in discount rate, growth rate, or terminal value can produce large changes in conclusion. A 1% change in discount rate can move value 5-10%. A 1% change in terminal growth rate can move value 5-15%. Defensible DCF includes sensitivity analysis showing how the conclusion moves with key inputs.

Can DCF produce negative values?

If projected cash flows are persistently negative (business operating at a loss), DCF can produce zero or negative values. In practice, this typically signals the going concern premise doesn’t apply — liquidation value or another method should substitute.

Working with a Business Valuation Professional on DCF

DCF is a powerful but input-sensitive method. The discount rate, projection assumptions, terminal value, and capital expenditure forecasts all require professional judgment grounded in empirical data. For any formal valuation purpose, a credentialed business valuation professional applies DCF in combination with other methods and reconciles across approaches.

Joey Friedman CPA PA, through its President Joey N. Friedman, CPA, ABV, MAcc, MIB, provides ABV-credentialed business valuation services throughout Florida. The firm’s valuation practice applies DCF where projections support it, capitalization of earnings where they don’t, and market approaches alongside both. Contact the firm to discuss your specific situation.

About Joey Friedman CPA PA

Joey Friedman CPA PA is a Florida professional association providing forensic accounting, business valuation, expert witness, and litigation support services. The firm is led by Joey N. Friedman, CPA, ABV, MAcc, MIB, who serves as the firm’s President.

All services described in this article are provided by Joey Friedman CPA PA. Engagement letters and professional services are issued by the firm. Joey N. Friedman signs in his capacity as the firm’s President — as an officer and agent acting on behalf of Joey Friedman CPA PA, not in any personal or individual capacity. Mr. Friedman’s professional credentials — including CPA license, ABV (Accredited in Business Valuation, AICPA), and ACFE membership — are exercised under the firm.

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