Discounted cash flow (DCF): how to value a small business, with a worked example

Short answer: a discounted cash flow (DCF) values a business as what its future cash is worth today. Forecast the free cash flow for the next five years, add a terminal value for every year after that, and divide each year’s cash by (1 + discount rate) once for every year you wait for it. A cleaning company making $100,000 of free cash flow, growing it about 4% a year, is worth about $473,000 at a 25% discount rate. The discount rate is the return a buyer wants for the risk, and for a small owner-run business it is high, often 20% to 30% or more, which is why small businesses sell for a few years of their cash, not twenty. Small businesses are usually priced on a multiple of seller’s discretionary earnings or EBITDA, so use a DCF as a check on that price and to see what a change is worth, not as the only number.

The discounted cash flow formula

Step	What you work out
1. Free cash flow	Cash from trading less what you spend on equipment, before interest and loan repayments, for each of the next five years
2. Discount factor	1 ÷ (1 + discount rate) to the power of the year number
3. Present value	Each year’s free cash flow × its discount factor
4. Terminal value	Year 5 free cash flow × (1 + long-term growth) ÷ (discount rate − long-term growth)
5. Present value of the terminal value	Terminal value × the year 5 discount factor
6. Business value	The five present values + the present value of the terminal value
7. What the owner gets	Business value − loans + cash the business does not need

The cash is taken before interest and loan repayments because a DCF values the whole business, however it is funded. The loans come off at step 7. This is unlevered free cash flow; the unlevered vs levered free cash flow guide shows how it differs from the cash left for the owners after the lender is paid.

A worked example: a commercial cleaning company in Brisbane

These figures are made up. Sam owns a commercial cleaning company with 14 cleaners on contracts with offices and medical centres. Last year it made $100,000 of free cash flow, after company tax and after paying a manager’s wage for the job Sam does, because a buyer would have to pay someone to do it. Sam expects about 4% more each year from price rises and one or two new contracts, and uses a 25% discount rate.

Year	Free cash flow	Discount factor at 25%	Present value
1	104,000	0.800	83,200
2	108,000	0.640	69,120
3	112,000	0.512	57,344
4	117,000	0.410	47,923
5	121,000	0.328	39,649
Five years	562,000		297,236

The five years of cash add up to $562,000, but they are worth $297,236 today, because a buyer waits for it and might not get it all.

The terminal value

The business does not stop after year 5. The terminal value puts a figure on every year after that, assuming the cash grows 2% a year for good:

121,000 × 1.02 ÷ (0.25 − 0.02) = 123,420 ÷ 0.23 = $536,609 at the end of year 5.

Discounted back five years at 0.328, that is worth $175,836 today. The terminal value guide checks this figure with an exit multiple of EBITDA instead (3.5 times $150,000 gives $469,268 for the business) and shows how much it moves with the rate and growth.

The value

	$
Present value of years 1 to 5	297,236
add present value of the terminal value	175,836
Business value	473,072
less the van and equipment loans	40,000
What Sam’s shares are worth	433,072

$473,072 is about 4.7 times last year’s free cash flow. The terminal value is 37% of it, so more than a third of the value rests on what happens after year 5.

What moves the answer

Change	Business value
As above (25% rate, 2% long-term growth)	$473,072
Discount rate 20%	$607,087
Discount rate 30%	$387,154
Long-term growth 0%	$455,833
Long-term growth 4%	$493,594
$10,000 more free cash flow every year	$514,497

The discount rate moves the value most: five points either way changes it by $86,000 to $134,000. That is why two people can run a DCF on the same business and get very different answers, and why a buyer will argue for a higher rate. The useful line for running the business is the last one: $10,000 a year more free cash flow adds about $41,000 to the value, so a contract that keeps paying is worth far more than one good year. To work out whether one decision, such as a new contract or a second van, adds cash at all, count only the cash it changes: the incremental cash flow guide shows how, with a worked net present value.

Choosing the discount rate

The discount rate is the yearly return a buyer wants for putting their money into this business instead of somewhere safer. The riskier the cash, the higher the rate. There is no official rate for a small business, and only a valuer or broker can say what buyers of businesses like yours accept. The things that push it up:

• The business depends on the owner. If customers come because of you, a buyer is less sure the cash will stay.
• A few customers make most of the sales. Losing one would cut the cash a lot. The customer concentration calculator shows how exposed you are.
• The figures jump around. Three steady years support a lower rate than one great year after two poor ones.
• No contracts. Recurring work on signed contracts is less risky than one-off jobs.

Large listed companies are often valued at about 8% to 12%. Small private businesses are much riskier and harder to sell, so rates of 20% or more are normal. Try two or three rates, as in the table above, rather than trusting one.

How to get the figures from Xero

1. Run Accounting › Reports › Statement of Cash Flows for your last full year, and use Compare with for the two years before. Note Net cash flows from operating activities and the cash spent on assets in investing activities. The Xero Statement of Cash Flows guide explains each section.
2. Work out free cash flow: operating cash flow less what you spent on equipment and vehicles. The free cash flow calculator does it from either operating cash flow or net profit.
3. Add back the interest you paid (it is on the Profit and Loss), because a DCF values the business before its loans.
4. If you pay yourself less than a manager would cost, take a fair wage off; if you pay yourself more, add the difference back. True profit covers the market-rate wage.
5. Forecast five years from there. The cash flow forecast template helps with the next twelve months; after that, keep growth modest and explain every jump.
6. Note the loan balances and the cash in the bank from the Balance Sheet for step 7.

In a spreadsheet, =NPV(25%, B2:B6) gives the present value of five years of cash in B2 to B6, as long as each year’s cash comes at the year end, which is what the table above assumes. Add the terminal value divided by 1.25^5. Menu names move between Xero releases and regions, so search Xero Central for the report name if your screen differs.

Common mistakes

• Using profit instead of cash. Profit ignores equipment you buy and money stuck with customers. A DCF needs free cash flow.
• Forgetting the owner’s wage. If you take a low salary and the rest as dividends, the cash looks higher than a buyer would get after paying someone to do your job.
• Growth that never slows. 15% a year for five years, then 5% for ever, makes almost any business look valuable. Long-term growth should be at or below inflation.
• A discount rate fit for a large company. At 10%, Sam’s business would look worth well over a million dollars. No buyer of a 14-person cleaning company will pay that.
• Counting the loans twice. Take interest out of the cash and the loans off the value, and you have charged for the debt twice. Value the cash before interest, then take the loans off once.
• Treating the result as the price. The price is what a buyer will pay. A DCF tells you whether an offer is reasonable and what to improve before you sell.
• Running a DCF on a single purchase. For one machine or van, the first question is simpler: how long until it pays for itself? The payback period calculator answers that, with and without interest.

Common questions

What is a discounted cash flow? It is a way of valuing a business, or any investment, by working out what its future cash is worth today. You forecast the cash for several years, add a value for the years after, and divide each year’s cash by one plus a discount rate for each year you wait. The total is the value now.

How do you calculate discounted cash flow? For each future year, divide the free cash flow by (1 + discount rate) raised to the year number, then add them up. Add a terminal value for the years after the forecast, discounted the same way. For example, 104,000 received in a year is worth 104,000 ÷ 1.25 = 83,200 today at a 25% rate.

What discount rate should a small business use? There is no single answer. Small private businesses are risky and hard to sell, so buyers usually want 20% a year or more, and more again if the business depends on the owner or a few customers. Try several rates and ask a broker or valuer what applies to businesses like yours.

What is terminal value in a DCF? It is the value of all the cash after the forecast years, worked out as the last year’s cash × (1 + long-term growth) ÷ (discount rate − long-term growth). For a small business it is often a third or more of the total, so keep the long-term growth modest.

Is DCF a good way to value a small business? It is a useful check, but most small businesses are priced on a multiple of seller’s discretionary earnings or EBITDA, because buyers compare with what similar businesses sold for. A DCF shows whether that multiple makes sense for your cash and what a change, such as a new contract, is worth.

What is the difference between DCF and NPV? Net present value (NPV) is the present value of the future cash less what you pay for it today. A DCF valuation is the present value of the future cash on its own, which is the most a buyer could pay and still get their required return. If they pay less, the NPV of their purchase is positive.

Know what your business makes, every Monday

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