Discounted Cash Flow (DCF) Explained [With Formula]

When evaluating the worth of a business or investment opportunity, few tools are as foundational as Discounted Cash Flow (DCF) analysis. At its core, DCF is a method used to estimate the present value of a business or asset based on its expected future cash flows. The concept may sound abstract, but it’s rooted in a simple financial truth: money today is worth more than the same amount in the future due to its potential earning capacity. This principle, known as the time value of money, sits at the heart of DCF.

For small business owners, understanding discounted cash flow is a strategic advantage. Whether you’re looking to attract investors, apply for funding, or make long-term planning decisions, DCF gives you a structured way to assess whether future income is likely to justify today’s investment. Rather than relying on surface-level projections or industry averages, DCF allows you to evaluate the intrinsic value of your business based on its unique cash flow profile and risk exposure.

By projecting future earnings and then “discounting” them back to present-day values using a rate that reflects both inflation and business risk, DCF helps quantify what those future dollars are really worth today. This makes it a powerful tool not only for valuing a business, but also for comparing investment opportunities, estimating acquisition potential, or weighing the long-term impact of major strategic decisions.

How the DCF Formula Works

At its core, the Discounted Cash Flow (DCF) formula helps determine how much a stream of future cash flows is worth today. It does this by “discounting” future earnings using a rate that reflects both the time value of money and the risk associated with those cash flows.

Here’s the basic structure of the formula:

DCF = (Cash Flow in Year 1 / (1 + Discount Rate)^1) + (Cash Flow in Year 2 / (1 + Discount Rate)^2) + …

Each future cash flow is adjusted back to its present value, and then all of those present values are added together to estimate the total worth of the business or investment.

Step-by-Step Example

Let’s say your business expects to generate $100,000 in free cash flow each year for the next 3 years, and you use a 10% discount rate to account for risk and opportunity cost. Here’s how that would play out:

• Year 1: $100,000 / (1 + 0.10)^1 = $90,909
• Year 2: $100,000 / (1 + 0.10)^2 = $82,645
• Year 3: $100,000 / (1 + 0.10)^3 = $75,131
  

Total DCF = $248,685

This means that even though your business expects to generate $300,000 in future cash, it’s only worth about $248,685 today when risk and time are factored in. That’s the power of DCF—it helps you understand the true, present-day value of tomorrow’s earnings.

DCF is especially helpful for businesses with relatively predictable revenue, such as those with strong customer retention or recurring income models. It brings discipline to business valuation by anchoring it in actual cash flow potential.

Key Components of a DCF Model

A Discounted Cash Flow model isn’t just about plugging numbers into a formula—it’s about making informed assumptions. The accuracy of your DCF valuation depends heavily on the quality of the inputs. Here are the three most important components to understand:

Free Cash Flow (FCF)

Free Cash Flow represents the money a business generates after covering its operating expenses and capital expenditures. It’s the cash that’s available to be distributed to investors or reinvested into the company. In most DCF models, Free Cash Flow is projected over a 3- to 5-year period based on historical data and growth expectations.

For small businesses, estimating FCF might involve looking at net income, adjusting for non-cash expenses like depreciation, and subtracting capital expenditures. Getting this number right is crucial, as it forms the foundation of your entire valuation.

Discount Rate

The discount rate reflects both the time value of money and the risk associated with the business’s future cash flows. For established companies, this is often based on their Weighted Average Cost of Capital (WACC)—a blend of the cost of debt and the cost of equity. For small or early-stage businesses, it’s common to use a higher discount rate to account for additional uncertainty and limited market data.

Choosing the right discount rate is more art than science. Go too low, and you overvalue the business. Go too high, and you might undervalue an opportunity with real potential.

Terminal Value

Since most DCF models only forecast a limited number of years, a large portion of a business’s value often comes from the terminal value—an estimate of what the business will be worth beyond the projection period. There are two common ways to calculate it:

• Perpetuity Growth Model: Assumes the business grows at a constant rate forever.
• Exit Multiple Method: Assumes the business is sold at the end of the forecast period for a multiple of earnings or revenue.

Terminal value can account for more than half of a company’s DCF valuation, so careful modeling is essential.

When to Use DCF Analysis

Discounted Cash Flow analysis is one of the most respected methods for assessing the value of a business or investment—but it’s not universally applicable. It works best when you have reliable cash flow projections and a clear understanding of your cost of capital.

Here are some of the most common situations where DCF shines:

Valuing a Business

Whether you’re preparing for a sale, attracting investors, or buying out a partner, DCF can help determine a business’s intrinsic value based on what it’s expected to earn in the future. Unlike methods based on industry multiples, DCF offers a more customized valuation rooted in your business’s actual performance and growth potential.

Evaluating Investment Opportunities

Small business owners often face decisions about new product lines, expansions, or capital investments. DCF allows you to evaluate whether those projects are likely to deliver a return that justifies the upfront cost—by estimating how much future income is worth today.

Seeking Funding or Loans

When applying for funding, especially with lenders or institutional investors who take a long-term view, having a DCF analysis can strengthen your business case. It shows that you’ve thought critically about future performance, risk, and value generation.

Comparing Strategic Scenarios

Should you invest more in marketing, open a second location, or acquire a competitor? DCF lets you run different forecast models under varying assumptions, helping you make apples-to-apples comparisons based on present-day value.

Limitations and Considerations

While Discounted Cash Flow is a powerful valuation tool, it’s far from foolproof. Its accuracy hinges on the quality of the assumptions that go into it. For small business owners, this means being especially cautious about forecasting and risk modeling.

Sensitivity to Assumptions

DCF models are extremely sensitive to small changes in inputs—especially the discount rate and long-term growth rate. A 1–2% shift in either direction can significantly change the final valuation. If your assumptions are too optimistic or conservative, the result can either overinflate or understate the true value of your business.

Forecasting Is Hard

Many small businesses don’t have years of stable financials to reference when projecting future cash flows. Startups and early-stage companies often experience uneven growth, making long-term forecasts speculative at best. Without solid historical data, even the most well-structured model can lead to misleading conclusions.

Estimating the Right Discount Rate

There’s no single formula for choosing a discount rate—especially for privately held businesses. While public companies may rely on calculated WACC, small businesses often have to estimate based on industry benchmarks, risk premiums, or investor expectations. Misjudging risk can make your valuation unreliable.

Over Reliance on Terminal Value

In many cases, the terminal value can represent more than half of the total DCF. That means a huge portion of your valuation rests on what the business might be worth far into the future, often based on a single assumed growth rate. If that estimate is off, the entire model can become skewed.