Discounted Cash Flow Valuation: A Practical Walkthrough for SME Owners

Introduction

The Discounted Cash Flow (DCF) method is widely regarded as the most theoretically sound approach to business valuation. Rather than relying on market comparables or industry multiples, DCF values a business based on its ability to generate cash—the fundamental source of economic value.

But DCF models are only as good as their assumptions. This article walks through the DCF process in practical terms, explaining each component and how Australian SME owners and valuers approach it.

The Core Concept

DCF valuation rests on a simple principle: a dollar today is worth more than a dollar tomorrow. The DCF method takes all expected future cash flows and discounts them back to their present value using a rate that reflects the risk of receiving those cash flows.

For a step-by-step Excel walkthrough of building a DCF model with practical examples, see Business Valuation for SMEs: A Practical Excel Model.

The basic formula:

Business Value = Sum of PV of Projected Cash Flows + PV of Terminal Value

Where PV (Present Value) = Future Cash Flow / (1 + Discount Rate) ^ Year

Step 1: Forecast Future Cash Flows

The starting point is a projection of free cash flows, typically for 5-7 years. For most SMEs, a 5-year forecast is appropriate—beyond that, the assumptions become too speculative to be meaningful.

What to include in the forecast:

• Revenue projections by stream or product line
• Operating expenses and margins
• Capital expenditure requirements
• Changes in working capital (receivables, payables, inventory)
• Tax on operating profits

The quality of the DCF depends almost entirely on the quality of these projections. A well-researched, conservatively prepared forecast is worth far more than a sophisticated modelling technique applied to poor assumptions.

Step 2: Determine the Discount Rate

The discount rate is the most debated input in any DCF. It represents the return an investor would require to invest in this business versus a risk-free alternative.

The building blocks of a discount rate:

For established SMEs with stable earnings and manageable risk, discount rates typically sit in the 12-18% range. For early-stage or high-risk businesses, 20-25% is common.

The effect of discount rate on value is dramatic:

A 5% difference in discount rate can change the valuation by over 20%. This is why getting the discount rate right is critical.

Step 3: Calculate the Terminal Value

Beyond the forecast period, we need to estimate the value of the business's ongoing cash flows. This is the terminal value, and for most SMEs it represents 60-80% of the total DCF value.

The Gordon Growth Model approach:

Terminal Value = Final Year FCF × (1 + Growth Rate) / (Discount Rate - Growth Rate)

Key considerations:

• The growth rate should reflect long-term sustainable growth, not short-term aggressive targets
• For most Australian SMEs, a terminal growth rate of 2-3% (matching long-term GDP growth or inflation) is appropriate
• The discount rate minus growth rate (the "spread") should be at least 5% to avoid unrealistically high terminal values

Step 4: Discount and Sum

Apply the discount rate to each year's projected cash flow and the terminal value, then sum them all.

Worked example:

This suggests a business value of approximately $2.85M based on the DCF methodology.

Step 5: Sanity Check and Sensitivity Analysis

A DCF should never be the only method used. Cross-check against market multiples and asset-based approaches to ensure the result is in a reasonable range.

Run a sensitivity table showing how the valuation changes with different discount rates and growth assumptions:

This table highlights the range of reasonable outcomes and prevents false precision.

When DCF Works Best—and When It Doesn't

Best for:

• Businesses with predictable, growing cash flows
• Established companies with clear operating histories
• Situations where comparable company data is limited

Less suitable for:

• Early-stage or pre-revenue businesses
• Businesses with highly volatile earnings
• Asset-heavy businesses where liquidation value is more relevant
• Very small businesses (under $500K revenue) where simpler methods are more practical

Conclusion

DCF is a powerful valuation tool when applied correctly, but its apparent precision can be misleading. The model is only as good as its assumptions. At BizVal, we use DCF as one of multiple methodologies, weighting it appropriately based on the quality of available data and the nature of the business.

Contact us to discuss how DCF analysis applies to your business valuation requirements.

Frequently Asked Questions

Why does the terminal value dominate the DCF?

Because the terminal value captures all cash flows beyond the forecast period. To check if your terminal value is reasonable, it should represent no more than 70-80% of the total DCF value. If it's higher, your forecast period may be too short or your assumptions too aggressive.

Can I use DCF for a business that isn't profitable yet?

Technically yes, but the uncertainty is much higher. In practice, DCF is most reliable for profitable businesses with predictable cash flows. For early-stage businesses, market comparables or milestone-based approaches are often more appropriate.

What discount rate do you use for a typical Australian SME?

For an established SME with stable earnings, manageable debt, and reasonable diversification, we typically use a discount rate in the 14-18% range. Each engagement is assessed on its specific risk profile.

Does DCF account for debt?

Standard DCF calculates enterprise value using free cash flow to the firm, which excludes financing decisions. Debt is subtracted later to arrive at equity value. Using free cash flow to equity would incorporate debt service directly.