Business Valuation: Discounted Cash Flow (DCF) and Multiples

What you'll learn

The difference between book value, enterprise value and equity value.
How to calculate free cash flow from the financial statements.
How to value a business with discounted cash flow (DCF): WACC, terminal value and net debt.
How to cross-check with an EV/EBITDA multiple, and how small businesses are often priced.
How to present a valuation as a range with a sensitivity table.

"What's my business worth?" The question shows up with a new partner, a buyer, a lender, a divorce or an estate. The answer isn't on the balance sheet: equity there (lesson 9) reflects what was invested in the past, not the cash the business will generate in the future. In this final lesson you'll use everything from the course to apply the two main valuation methods.

$1.87MBrightside's enterprise value with a discounted cash flow model

61%of that value comes from the terminal value, beyond year 5

$1.59M–$1.80Mreasonable range for the owner's equity, from the sensitivity table

Three different values

Concept	What it measures
Book value (equity)	Assets minus liabilities in the books. Looks backward.
Enterprise value (EV)	What the business itself is worth based on the cash it can generate, regardless of how it's financed.
Equity value	What belongs to the owners: enterprise value minus net debt.

Equity value = Enterprise value − Interest-bearing debt + Cash
             = Enterprise value − Net debt

Two coffee companies, one heavily indebted and one debt-free, can have the same enterprise value, but their owners don't own the same amount: in the first, part of the value belongs to the bank.

Here's the process you'll follow:

Step 1Project free cash flowFive years of cash the business generates after taxes and reinvestment.
Step 2Set the discount rateThe WACC, which reflects risk and what lenders and owners expect.
Step 3Estimate the terminal valueThe value of all cash flows after year 5.
Step 4Discount, add up and subtract net debtThen cross-check with multiples and present a range.

Step 1: free cash flow

Free cash flow (FCF) is the cash the business generates after taxes and after investing what it needs to keep running and growing. It's what could be paid out to lenders and owners:

  EBITDA
− Depreciation and amortization
= EBIT (operating income)
− Taxes on EBIT
+ Depreciation and amortization (not a cash outflow)
− Capital expenditures (capex)
− Increase in working capital
= Free cash flow

A few years on, Brightside has grown to three locations, and an investor offers to buy 30% of it. Maya projects five years in thousands of dollars, with depreciation of $90k, capex of $105k and a $15k increase in working capital each year. Although Brightside is a pass-through LLC, valuations normally apply an income tax to EBIT so that buyers compare businesses on the same footing; we'll use 25% (the 21% federal corporate rate plus an allowance for state tax).

Year	1	2	3	4	5
EBITDA	360	396	435	465	486
EBIT (EBITDA − 90)	270	306	345	375	396
Taxes (25% of EBIT)	67.5	76.5	86.25	93.75	99.0
FCF (EBIT − taxes + 90 − 105 − 15)	172.5	199.5	228.75	251.25	267.0

1. Why is depreciation added back when calculating free cash flow?

Because it's extraordinary income
Because it was subtracted to get EBIT and taxes, but it isn't a cash outflow
Because the IRS requires it

Depreciation lowers profit (and taxes), but the cash left when the equipment was bought. That outflow is captured in capex instead.

Step 2: the discount rate (WACC)

Future cash is brought back to today's dollars with a rate that reflects risk and what the business's financiers require: the weighted average cost of capital (WACC). It blends what owners expect (the cost of equity) with what lenders charge (the cost of debt, which is cheaper after tax because interest is deductible):

WACC = %Equity × Cost of equity + %Debt × Cost of debt × (1 − tax rate)

Brightside: 75% equity at 18%, 25% debt at 8%, 25% tax rate
WACC = 0.75 × 18% + 0.25 × 8% × 0.75 = 13.5% + 1.5% = 15%

Why would an owner expect 18%? Because she could put her money in safer places, like Treasury bonds or an S&P 500 index fund, and she'll only accept the risk of a small, owner-dependent business for a clearly higher expected return. Large, stable companies have a lower WACC; small, young or riskier businesses, a higher one.

Step 3: the terminal value

The business doesn't vanish after year 5. The value of every cash flow after that is summarized in the terminal value, which assumes a modest perpetual growth rate (g), usually close to long-term inflation:

Terminal value (year 5) = FCF year 5 × (1 + g) ÷ (WACC − g)
                        = 267.0 × 1.03 ÷ (0.15 − 0.03) = 2,291.75

The terminal value carries a lot of weight

Here it's 61% of enterprise value, which is common. That's why small changes in g or WACC move the result a lot, and why a g above the long-term growth of the economy makes no sense: no company can outgrow the economy forever.

Step 4: discount and add up

Year	FCF	Factor 1 ÷ 1.15ⁿ	Present value
1	172.5	0.8696	150.0
2	199.5	0.7561	150.9
3	228.75	0.6575	150.4
4	251.25	0.5718	143.7
5	267.0	0.4972	132.7
Terminal value	2,291.75	0.4972	1,139.4
Enterprise value (EV)			1,867.1
− Net debt (loans 240 − cash 60)			(180.0)
Equity value			1,687.1

Of the $1,867.1k enterprise value, $727.7k (39.0%) comes from the next five years of cash flow and $1,139.4k (61.0%) from the terminal value.

A 30% stake is worth about 30% × $1,687.1k ≈ $506k. In Excel or Google Sheets the whole calculation fits in one cell: =NPV(15%,B6:F6)+G6/(1+15%)^5, with the five cash flows in B6:F6 and the terminal value in G6.

2. A company's enterprise value is $1,500k. It has $360k of loans and $90k of cash. What is its equity value?

$1,500k
$1,230k
$1,140k

Net debt = $360k − $90k = $270k. Equity = $1,500k − $270k = $1,230k. Forgetting the cash gives $1,140k.

Cross-checking with multiples

The second method compares the business with similar companies that were sold or trade publicly. The most common multiple is EV/EBITDA: how many years of EBITDA a buyer paid. If comparable coffee businesses sold for 5.5 times EBITDA and Brightside's current EBITDA is $330k:

Enterprise value = $330k × 5.5 = $1,815k
Equity value     = $1,815k − $180k = $1,635k

The two methods land close together ($1,687k and $1,635k), which builds confidence. If they were far apart, you'd revisit the projections or the comparables.

How Main Street businesses are often priced

For many very small U.S. businesses, brokers price deals on a multiple of seller's discretionary earnings (SDE): profit before the owner's own salary, perks, interest and depreciation, because the buyer usually steps into the owner's job. Larger companies with a management team are priced on EBITDA. Make sure you know which earnings figure a multiple refers to before comparing.

Sensitivity: a range, not a number

A serious valuation is presented as a range. Brightside's equity value ($ thousands) under different WACC and perpetual growth assumptions:

WACC \ g	2%	3%	4%
13%	1,930	2,079	2,261
15%	1,589	1,687	1,803
17%	1,340	1,408	1,486

Equity value estimates ($ thousands)

DCF, low (15%, g 2%)1,589

EV/EBITDA multiple1,635

DCF, base case1,687

DCF, high (15%, g 4%)1,803

A spreadsheet's two-variable data table builds this grid automatically. A reasonable range here runs from about $1.59 million to $1.80 million: that's the negotiating zone.

3. What happens to a DCF valuation if you raise the WACC?

It rises, because the business is more profitable
Nothing changes
It falls, because future cash flows are discounted more heavily

A higher rate reflects more risk and shrinks the present value of every cash flow, especially the terminal value.

4. Which perpetual growth rate (g) is most defensible for a mature coffee business?

2.5%, close to long-term inflation
8%, its growth over the last three years
15%, the same as its WACC

Terminal growth must be sustainable forever, so it should stay near long-term inflation or economic growth. At g equal to WACC, the formula breaks down entirely.

What the number doesn't tell you

Are the projected sales realistic compared with the historical trend (lesson 12)?
Does the business depend on the owner? Buyers discount heavily for that.
Are the financial statements reliable, reconciled and ideally reviewed by a CPA?
Are leases, key staff and supplier terms secure enough to last after a sale?

Clean books and less owner dependence don't just make a valuation easier to defend; they make the business worth more.

Practice exercise: value a distributor

A distributor generates a stable free cash flow of $150k a year. You project five equal years and then 2% perpetual growth. The WACC is 12%, net debt is $300k and current EBITDA is $240k. Similar companies sell for 6 times EBITDA.

Calculate the present value of the five cash flows.
Calculate the terminal value and discount it to today.
Find enterprise value and equity value with DCF.
Compare with the multiples method.

See solution

1) PV of 5 flows of $150k at 12%:  =PV(12%,5,-150)          → $540.7k
2) Terminal value: 150 × 1.02 ÷ (0.12 − 0.02)               = $1,530.0k
   Discounted: 1,530 ÷ 1.12^5 = 1,530 × 0.5674               =   $868.2k
3) Enterprise value: 540.7 + 868.2                          = $1,408.9k
   Equity value: 1,408.9 − 300                              = $1,108.9k
4) Multiples: 240 × 6 = $1,440k → equity 1,440 − 300        = $1,140.0k

Both methods agree on equity of roughly $1.11 to $1.14 million. An offer of $900k would be low; an asking price of $1.5 million would need to justify much faster growth than assumed.

Summary

Book value looks at the past; a valuation looks at the cash the business will generate.
Free cash flow = after-tax EBIT + depreciation − capex − increase in working capital.
DCF discounts the cash flows and terminal value at the WACC; subtract net debt to get equity value.
EV/EBITDA (or SDE for very small businesses) is the standard cross-check.
Always present a range with a sensitivity table.

Course recap

Level 1, Beginner: what accounting is, the accounting equation, the chart of accounts and debits and credits.
Level 2, Intermediate: the journal, ledger and trial balance; inventory with FIFO, LIFO and average cost; adjusting and closing entries; the income statement.
Level 3, Advanced: the balance sheet, cash flow and ratios, budgeting and financial statement analysis.
Level 4, Expert: U.S. small business taxes, payroll and the cost of an employee, cost accounting and pricing, and business valuation.

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