The idea behind Discounted Cash Flow, or DCF for short, is surprisingly human. A euro you won't receive for five years is worth less today than a euro in your hand right now. Why? You could invest today's money, inflation eats away at it, and a lot can happen in five years. DCF takes this everyday logic and turns it into a valuation method.
With DCF you don't look at the profit on the tax return, but at free cash flow: the money that actually remains after all costs and necessary investments and could be withdrawn. That is more honest. It shows what the business truly earns.
You estimate these future cash flows a few years ahead, usually three to five. For the period after that, people often add a so-called terminal value: a simplified residual value that assumes the business keeps running beyond your forecast.
Here's how the math works. Each future cash flow is "discounted", meaning it is scaled down to today's value. This rate (called WACC for larger firms) reflects risk. The more uncertain the business, the higher the rate, the lower today's value. A cash flow of 50,000 euros a year from now is worth about 45,455 euros today at a 10 percent rate.
All discounted cash flows plus the discounted residual value together give the company value. For small businesses DCF is rarely the only method. But it forces you to think honestly about the future instead of just looking backward.
For business sellers
As a seller, DCF is your chance to make the value of your future prospects visible. If you've just opened a new location or landed a major client, that won't show up in the last few years' profit yet. In the estimated cash flow it will. Realistic, well-founded forecasts are worth their weight in gold here.
But be honest with yourself. Overly optimistic numbers get noticed in sale talks, and certainly during due diligence. A buyer will ask why revenue should suddenly rise if you yourself want to slow down. Back up your assumptions with orders, contracts or clear trends. Then a forecast becomes a credible argument for your price.
For corporate buyers
For you as a buyer, DCF is a tool against nasty surprises. After all, you're not buying the past, but what the business will bring you in the future. DCF forces you to look closely: do the customers stay even without the former owner? What investments are coming up? What actually remains at the end?
Use the discount rate as your safety cushion. If the business depends heavily on one person or a few customers, apply a higher rate. That lowers the value and protects you from overpaying. This turns a gut feeling into a defensible number you can take confidently into price negotiations.
Example
Take a small carpentry shop. You expect free cash flows of 60,000, 65,000 and 70,000 euros over the next three years. The discount rate is 10 percent. Discounted, that gives: 60,000 ÷ 1.10 = 54,545 euros; 65,000 ÷ 1.21 = 53,719 euros; 70,000 ÷ 1.331 = 52,592 euros. For the period after that you set a simplified residual value of 70,000 euros per year, divided by the rate: 70,000 ÷ 0.10 = 700,000 euros, discounted to today (÷ 1.331) that is 525,920 euros. Added together, this gives a company value of about 686,776 euros. That's your negotiating basis, not the fixed final price.
FAQ
What's the difference between profit and free cash flow?
Profit appears on the tax return and includes entries like depreciation that don't cost real money. Free cash flow shows what actually remains after necessary investments and could be withdrawn. DCF uses cash flow because it shows more honestly what you really hold in your hands.
How do I choose the right discount rate?
As a rule of thumb: the more uncertain the business, the higher the rate. For a stable small business, 8 to 12 percent is common; with strong owner dependency or few customers, considerably more. The rate isn't an exact figure but your safety buffer against risk.
Is the asking price worth it, or should I rather start my own business?
DCF helps exactly with this question. An existing business delivers cash flow, customers and a working routine from day one. A startup often takes years to get there. Weigh the DCF value against the asking price: if the price is below or level with it, you're buying time and security that a startup can't offer. If it's well above, negotiate or keep looking.
Is DCF alone enough to value a small business?
Rarely. For small businesses, DCF is usually used alongside simpler methods like the capitalized-earnings approach or the multiplier method. DCF then serves more as a reality check: do the future cash flows match the price being asked?
What is this terminal value and why is it so large?
The terminal value is the estimated residual value for the time after your forecast period. Because a business theoretically runs on indefinitely, this residual value often makes up the largest part of the total. That's why you should be cautious here and not calculate too optimistically.
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