DCF Valuation

What is a DCF valuation?

DCF valuation (discounted cash flow valuation) is a method of business valuation that derives a company's value from the cash surpluses that it is expected to generate in the future. These free cash flows are converted to their present value, that is, discounted. The sum of these present values is the enterprise value. The interest rate used for this expresses the return that capital providers require for the risk they take on. The terms DCF method, DCF approach and DCF model are also in use.

The basic idea is simple: a company is worth as much as the money it will bring its capital providers in future. A euro that flows only in five years counts for less than a euro today, because it is uncertain and cannot be invested until then.

In Germany, the valuation standard IDW S 1 of the Institute of Public Auditors in Germany (Institut der Wirtschaftsprüfer, IDW) recognises the method alongside the capitalised earnings method (Ertragswertverfahren); with the same assumptions, both lead to the same result. Buyers use the DCF valuation to determine their walk-away price, that is, the maximum price up to which the purchase is worthwhile. Auditors use it in expert opinions and in testing whether balance sheet values are still recoverable, financial investors to check the plausibility of their offers. The basis is an integrated financial model with planning of earnings, balance sheet and liquidity. For price setting in financing rounds of young companies it is of secondary importance, but it is useful there too as a touchstone for planning and price expectations.

Calculating a DCF valuation: formula and steps

Formula: enterprise value = sum of the present values of the free cash flows + present value of the terminal value; present value = cash flow ÷ (1 + WACC) to the power of the number of years until payment

In its common form, the weighted average cost of capital approach, a DCF valuation follows a fixed sequence:

1. Planning of the free cash flows for each year of the detailed planning phase.
2. Determination of the terminal value for the period afterwards.
3. Discounting of all cash flows and the terminal value at the weighted average cost of capital (WACC).
4. Sum of the present values as the enterprise value, that is, as the value of the operating business for owners and lenders together.
5. Bridge to the equity value, the value of the shares (equity bridge): deduction of net financial debt (financial debt minus liquid funds) and debt-like items.
6. Sensitivity analysis, that is, recalculation with changed values for the most important assumptions.

There are also two variants. The adjusted present value approach records the value of the tax saving from debt financing separately. The net approach (flow to equity) discounts the cash flows to the owners at the cost of equity and delivers the equity value directly. With consistent assumptions, all three variants lead to the same result. In practice the calculation sits in a spreadsheet fed from the integrated financial model; a ready-made template does not replace the justification of the assumptions.

Free cash flows and the detailed planning phase

Free cash flow is the liquidity that the operating business generates for all capital providers after taxes and investments. It is derived from operating earnings before interest and taxes (EBIT) in four steps:

1. Deduction of the income taxes that would apply to EBIT if the company were debt-free.
2. Addition of depreciation and amortisation, because they reduce earnings without cash leaving in that year. The cash outflow is instead recorded in the year of the investment.
3. Deduction of investments in property, plant and equipment and intangible assets such as software.
4. Deduction of the build-up of working capital, in simplified terms inventories and receivables less trade payables.

Interest is left out because it is captured through the discount rate and the bridge to equity value.

The detailed planning phase usually covers three to five years. For fast-growing companies, as a rule of thumb it extends seven to ten years, until a steady state is reached in which growth, margins and investments remain permanently stable. Between the detailed planning and the perpetuity, a rough planning phase is then often inserted in which growth falls step by step to a sustainable level. The yardstick for reliability is planning accuracy: acquirers compare earlier plans with the figures actually achieved and apply their own assumptions where there are deviations.

Terminal value: perpetuity or exit multiple

The terminal value summarises all cash flows after the detailed planning phase in a single figure. Widely used is the perpetuity with constant growth under the Gordon formula: terminal value = free cash flow of the first year after the planning period ÷ (cost of capital minus permanent growth rate). The terminal value calculated this way applies at the end of the last planning year and is therefore still converted to today using that year's discount factor.

The growth rate must lie below the cost of capital, otherwise the formula yields no meaningful result. It should also not exceed the long-term nominal growth of the economy (including inflation). At the same time, the cash flow in the terminal value must contain the investments that this growth requires.

Alternatively, the terminal value is set as a multiple of a metric of the last planning year, usually EBITDA (exit multiple). This method is widespread but combines a present value calculation with a market price and makes the result dependent on the market environment. Careful models calculate both methods and check which growth rate the chosen multiple implicitly assumes. For growth companies, the far greater part of the enterprise value often falls on the terminal value, which is why its assumptions need particular justification.

Discounting at the weighted average cost of capital

The free cash flows belong to equity and debt providers jointly. They are therefore discounted at a blended rate of the cost of equity and the after-tax cost of debt, weighted by market values or a target capital structure. The cost of equity is usually derived with the capital asset pricing model (CAPM). It combines the base rate of risk-free government bonds, the market risk premium (the excess return that investors demand for entrepreneurial risk) and the beta factor. The latter measures how strongly comparable companies fluctuate with the overall market. How the discount rate arises in detail and what target returns venture investors apply is described in its own entry.

The calculation must be internally consistent. Nominal cash flows require a nominal interest rate, cash flows to all capital providers the weighted average cost of capital, cash flows to the owners the cost of equity. Every risk may be captured only once: either through a cautious haircut in the plan or through a premium in the interest rate.

Worked example: DCF valuation over three planning years

A software company plans for three years. The weighted average cost of capital is 10%, the permanent growth rate after the planning period 2%, net financial debt EUR 2.0 million. The terminal value is calculated as a perpetuity at the end of year 3. For simplicity, the tax rate used is the total burden of corporate income tax, solidarity surcharge and trade tax of around 30% (as of 2026). The gradual reduction of corporate income tax to 10% by 2032, decided to begin in 2028, would raise later cash flows and the terminal value; the example simplifies by calculating with a constant rate.

• Free cash flow year 1: EBIT EUR 1.5 million minus 30% tax = 1.05, plus depreciation and amortisation 0.40, minus investments 0.35, minus build-up of working capital 0.10 = EUR 1.00 million
• Free cash flows year 2 and year 3 according to plan: EUR 1.2 and 1.4 million
• Discount factors at 10% (today's value of one euro from year 1, 2 and 3): 1 ÷ 1.10 = 0.9091; 1 ÷ 1.21 = 0.8264; 1 ÷ 1.331 = 0.7513
• Present values: 1.0 × 0.9091 = 0.9091; 1.2 × 0.8264 = 0.9917; 1.4 × 0.7513 = 1.0518; total EUR 2.9526 million
• Terminal value under the Gordon formula: cash flow year 4 = 1.4 × 1.02 = EUR 1.428 million; 1.428 ÷ (0.10 minus 0.02) = EUR 17.85 million at the end of year 3
• Present value of the terminal value: 17.85 × 0.7513 = EUR 13.41 million
• Enterprise value: 2.95 + 13.41 = EUR 16.36 million, of which about 82% falls on the terminal value
• Equity value: 16.36 minus 2.0 = EUR 14.36 million

The sensitivity shows how strongly the result depends on two assumptions. With a cost of capital of 9%, the enterprise value rises to about EUR 18.76 million, with 11% it falls to about EUR 14.50 million. One percentage point on the interest rate thus changes the result by a good 11 to just under 15%. A growth rate of 1% instead of 2% gives about EUR 14.76 million, one of 3% about EUR 18.43 million. In a negotiation, therefore, the single value is not what is informative but the table of values across plausible assumptions.

Distinction: DCF, capitalised earnings method, multiples and LBO

• Capitalised earnings method (Ertragswertverfahren): discounts the surpluses to the owners at their required return. It resembles the net approach of the DCF valuation but relies on earnings planning under commercial law.
• EBITDA multiple: derives the value from market prices of comparable companies. The DCF, by contrast, reflects the company's own planning and is thus more independent of the market environment, but more dependent on its own assumptions.
• Venture capital method: looks only at the expected exit value at the end of the holding period and discounts it at a target return. Interim cash flows are not included.
• LBO model: the calculation model of a financial investor who finances an acquisition partly with debt (leveraged buyout). It determines what price the investor can pay given the financing and target return, and is not a method for determining an objectified value.

Common mistakes

• Profit instead of cash flow. Anyone who discounts net income overlooks investments and the build-up of receivables and inventories. Growing companies in particular tie up considerable funds in working capital.
• Terminal value without a steady state. If the terminal value starts at the end of a growth phase, high growth rates are in effect extended into eternity.
• Growth without investments. A permanent growth rate requires ongoing investments. If they are missing from the cash flow in the terminal value, the value is overstated.
• Risk captured twice. A high interest rate together with a plan that has already been cautiously discounted values the same risk twice.
• Bridge forgotten. The DCF value is an enterprise value. Without deducting financial debt, pension provisions and other debt-like items, the value of the shares is overestimated.
• Single value without sensitivity. A figure exact to the euro feigns a precision that the method does not provide.

Frequently asked questions

Is a DCF suitable for companies that are still making losses?

Only to a limited extent. Negative cash flows in the first years and a high share of terminal value make the result very sensitive to a few assumptions. Valuers then extend the detailed planning until sustainable profitability and often supplement it with scenarios with probabilities. For price setting in financing rounds, multiples and comparable rounds predominate.

What growth rate is appropriate for the perpetuity?

A cautious one. As a rule of thumb, 1 to 2% applies. Rates that are permanently above long-term nominal economic growth are hard to justify, because the company would otherwise, mathematically, eventually become larger than the economy.

Why does a buyer arrive at a different DCF value than the seller?

Because it calculates with its own planning, its own synergies and its own assessment of the risks. It reviews the seller's planning in due diligence, the review of the company before the purchase, discounts deviations and adds cost advantages from integration. The buyer's DCF determines the price up to which the acquisition is worthwhile for it.

What is a reverse DCF?

A calculation that starts from the price. It determines what growth and margins a company has to achieve for an offered or demanded price to be covered by the cash flows. The method is suited to tracing offers and valuation expectations back to their assumptions.

The Roemer Capital view

In a sale process, Roemer Capital uses the DCF mainly as a translation tool. From the financial model with base case, cautious case and optimistic case, it derives a valuation range. Incoming offers are calculated backwards: what growth and margin assumptions a buyer has to make to arrive at its price shows where the negotiation can start.

In financing rounds from Series A, the DCF is rarely the method that determines the price. Roemer Capital uses it nonetheless to check whether planning and valuation expectations fit together before investors ask that question. In fractional CFO engagements, in which it takes over the finance function for a limited period, it builds the integrated planning so that it supports this check.