Discounted Cash Flow (DCF) is a valuation method that estimates the present value of a business or investment by discounting its projected future cash flows back to today using a discount rate. It is the foundational framework for business valuation.
DCF rests on the time value of money: a dollar today is worth more than a dollar in the future because of the opportunity cost of capital and inflation risk. DCF converts projected future cash flows to their present-value equivalents by applying a discount rate — typically WACC or a required rate of return. Present Value = Future Cash Flow / (1 + discount rate)^n, where n = number of periods. A full DCF model projects Free Cash Flow to the Firm (FCFF) for 5-10 years, then calculates a terminal value (the value of all cash flows beyond the projection period), and discounts both back to present value. Business value = sum of discounted projected cash flows + discounted terminal value. DCF's strength is that it explicitly captures the quality, timing, and durability of cash flows — a business with reliable, growing cash flows is worth more than one with the same current earnings but declining trajectory. Its weakness is sensitivity to assumptions: changing the discount rate by 1% or terminal growth rate by 0.5% can shift the valuation by 20-30%. This makes DCF an art as much as a science — the output is only as good as the inputs. For small business financing, lenders and investors use DCF informally to assess whether projected cash flows justify the loan amount or equity valuation. SBA underwriting looks at whether the business's historical and projected cash flows support debt service — essentially a simplified DCF without the terminal value complexity.
Formal DCF models are more common in M&A transactions, SBA loan underwriting for acquisitions, and private equity investments than in standard working capital lending. For acquisition loans, lenders model the target business's projected free cash flows to determine if they can service the acquisition debt. For working capital, simpler DSCR analysis typically suffices.
Use WACC if you're valuing the whole business (debt + equity). Use the required return on equity if you're valuing only the equity portion. For small private businesses without formal WACC calculations, industry discount rates of 15-25% are commonly applied to reflect higher risk, illiquidity, and uncertainty compared to public companies.
Terminal value represents the value of all cash flows beyond the explicit projection period, captured as a single lump sum. The most common method: Terminal Value = Final Year FCF × (1 + growth rate) / (discount rate - growth rate). Terminal value often represents 60-80% of total DCF value — making the assumed long-term growth rate highly influential.
DCF is theoretically superior because it accounts for cash flow quality, growth, and risk. Revenue or EBITDA multiples are easier to compute and compare but can be misleading if comparable companies have different margins, growth rates, or capital structures. Best practice: use DCF as the primary method and market multiples as a cross-check.