The DCF method: valuing future cash flows
The Discounted Cash Flow (DCF) method starts from a simple principle: a company is worth the sum of the cash flows it will generate in the future, brought back to today. It is the most rigorous and most widely used method when you want to value a business for what it will produce, rather than for what the market pays for similar companies. Unlike multiples, which look at comparables, DCF looks at the business’s ability to generate cash over time. The flip side: it depends on the assumptions, and small changes can significantly alter the result.
The underlying idea: money has a time value
CHF 1,000 today is worth more than CHF 1,000 five years from now, because today’s money can be invested and carries less uncertainty. DCF translates this into numbers: every future cash flow is discounted using a rate that reflects risk and the cost of capital. The further away a cash flow lies in time, and the riskier the business, the less it is worth today.
The three ingredients
1. The cash flow projection
You build a plan, typically over five years, of the cash flows the business will generate. The reference measure is Free Cash Flow: the cash left over after covering operating costs, taxes, investments in fixed assets and changes in working capital.
Schematically:
- EBIT − notional taxes + depreciation and amortisation − investments (capex) − change in working capital = Free Cash Flow
The quality of the projection is everything: it must rest on growth, margin and investment assumptions that are consistent with the company’s history and with the market, not on wishful thinking.
2. The discount rate (WACC)
Cash flows are discounted at the WACC (weighted average cost of capital), which combines the cost of equity and the cost of debt, weighted according to the financial structure. It reflects the return that capital providers expect for the risk they take on. For an SME the WACC is higher than for a large listed company: more risk, less liquidity, greater dependence on the entrepreneur. Even a few percentage points of difference in the WACC shift the final value considerably.
3. The terminal value
The company does not shut down at the end of the plan: it keeps generating cash beyond the projection horizon. The terminal value captures this, usually with the perpetual growth formula (a modest, prudent growth rate applied to the cash flows beyond the final year) or by applying an exit multiple to the last year. Be careful: in SMEs the terminal value often accounts for most of the total value, so it must be handled with prudence — an overly generous growth rate artificially inflates the result.
From enterprise value to the price of the shares
The sum of the discounted cash flows and the terminal value gives the Enterprise Value. To arrive at the equity value — what belongs to the shareholders — you subtract the net financial position:
- Equity value = Enterprise Value − financial debt + cash
It is the same step as in the multiples method, and forgetting it leads to wrong numbers.
The limitations to know
- Sensitivity to assumptions: change the growth rate or the WACC by one point and the value can swing sharply. That is why you build several scenarios and a sensitivity analysis, not a single number.
- Difficult for start-ups: without a reliable track record, projections become fragile and the DCF loses its solidity.
- The risk of “making the numbers say what you want”: an elegant model is not automatically credible. The assumptions matter more than the formulas.
DCF and multiples together
In practice DCF is not used on its own. It sits alongside the multiples method (EV/EBITDA and the like): the first tells you how much the company is worth for the cash flows it will generate, the second how much the market pays for similar companies. When the two paths converge, the valuation is robust; when they diverge sharply, it is a signal that some assumption needs revisiting.
In summary
- DCF values the company as the sum of future cash flows discounted to today.
- Three elements are needed: the Free Cash Flow projection, the discount rate (WACC) and the terminal value.
- The terminal value carries a lot of weight: handle it with prudence.
- Subtract net debt to move from Enterprise Value to the value of the shares.
- Build scenarios and cross-check the result against multiples, instead of relying on a single figure.
How we help you
We build solid, defensible DCF models for Swiss entrepreneurs and SMEs: realistic projections, a WACC calibrated to actual risk, scenarios and sensitivity analysis, together with the multiples comparison. A valuation that holds up in negotiation. Let’s talk about your valuation.