Company valuation is one of the most important skills in finance – whether for investors, founders, or business consultants. One of the most proven and theoretically sound methods is the Discounted Cash Flow (DCF) valuation. This method allows you to determine the intrinsic value of a company based on its future cash flows.
In a time when startups and established companies alike are looking for solid valuation foundations, DCF analysis offers an objective basis for investment decisions. Whether you want to found a sock subscription service or evaluate a tech startup – the DCF method provides you with the necessary insights.
What is DCF and why is it crucial?
Definition of DCF valuation
The Discounted Cash Flow (DCF) valuation is a valuation method that calculates the value of a company based on the expected future free cash flows. These cash flows are discounted to their present value to account for the time value of money.
Core idea: One euro today is worth more than one euro in a year because today’s money can be invested and earn interest.
Why DCF is indispensable in company valuation
The DCF method is considered a fundamental valuation basis because it:
Is future-oriented: Unlike past-based metrics, DCF focuses on expected performance.
Is theoretically sound: It is based on the concept of the time value of money and cost of capital.
Is flexibly applicable: From startups to multinational corporations – DCF works across industries.
Creates an objective basis: It reduces subjective valuation factors and produces comprehensible results.
Application areas of DCF valuation
- Investment decisions: Valuation of acquisition targets
- Startup financing: Determining fair company values for investors
- Strategic planning: Valuation of business units and projects
- Stock market analysis: Determining the fair stock value
Core elements of DCF valuation
Free Cash Flow (FCF)
The Free Cash Flow is the heart of every DCF analysis. It represents the funds available to a company after all necessary investments.
FCF calculation: Free Cash Flow = EBIT × (1 - tax rate) + depreciation - capital expenditures - change in working capital
Discount rate (WACC)
The Weighted Average Cost of Capital (WACC) represents the weighted average cost of capital of a company. It considers both equity and debt costs.
WACC formula: WACC = (E/V × Re) + (D/V × Rd × (1-T))
Where:
- E = market value of equity
- D = market value of debt
- V = E + D (total capital)
- Re = cost of equity
- Rd = cost of debt
- T = tax rate
Terminal Value
Since companies theoretically exist indefinitely, the value after the explicit forecast period must be captured. This is where the Terminal Value comes into play.
Gordon Growth Model: Terminal Value = FCF(n+1) / (WACC - g)
Where g = long-term growth rate
Step-by-step guide to DCF valuation
Step 1: Historical financial analysis
Start with a thorough analysis of the past 3-5 years:
- Analyze revenue development
- Identify profitability trends
- Understand cash flow patterns
- Assess capital intensity
Step 2: Forecast free cash flows
Develop realistic forecasts for the next 5-10 years:
Revenue forecast: Consider market trends, competitive situation, and company strategy.
Cost structure: Analyze fixed and variable costs and their development.
Investments: Plan necessary Capex and working capital changes.
Step 3: Determine the discount rate
Cost of equity (Re): Use the Capital Asset Pricing Model (CAPM):
Re = Rf + β × (Rm - Rf)
Cost of debt (Rd): Determine current borrowing costs.
Weighting: Determine the optimal capital structure.
Step 4: Discount the cash flows
Discount all forecasted cash flows to present value using the WACC:
PV = FCF / (1 + WACC)^t
Step 5: Calculate Terminal Value
Calculate the terminal value and discount it as well:
PV Terminal Value = Terminal Value / (1 + WACC)^n
Step 6: Determine company value
Enterprise Value: Sum of all discounted cash flows plus discounted terminal value.
Equity Value: Enterprise Value minus net debt.
Practical example: DCF valuation of a sock subscription service
Let’s imagine we are valuing an innovative sock subscription service that delivers unique, trendy socks to its customers monthly.
Starting situation
- Business model: Monthly subscription for €19.99 per customer
- Current customer base: 5,000 subscribers
- Monthly churn rate: 5%
- Customer acquisition cost: €25 per customer
- Gross margin: 60%
Revenue forecast (5-year plan)
Year 1:
- Customers: 5,000 → 12,000 (due to marketing campaign)
- Monthly revenue: 12,000 × €19.99 = €239,880
- Annual revenue: €2,878,560
Years 2-5: Continuous growth with decreasing growth rate:
- Year 2: €4,200,000 (+46%)
- Year 3: €5,670,000 (+35%)
- Year 4: €7,280,000 (+28%)
- Year 5: €8,900,000 (+22%)
Cost structure and FCF development
Example calculation Year 3:
- Revenue: €5,670,000
- Gross profit (60%): €3,402,000
- Marketing & sales (25%): €1,417,500
- Personnel & administration (15%): €850,500
- EBITDA: €1,134,000
- Depreciation: €150,000
- EBIT: €984,000
- Taxes (25%): €246,000
- NOPAT: €738,000
- Capex: €200,000
- Change in working capital: €100,000
- Free Cash Flow: €438,000
DCF calculation
WACC determination:
- Cost of equity: 12% (high startup risk)
- Cost of debt: 6%
- Capital structure: 80% equity, 20% debt
- WACC: 10.56%
Terminal Value (Year 5):
- FCF Year 6: €1,200,000 (estimated)
- Long-term growth rate: 2%
- Terminal Value: 1,200,000 / (10.56% - 2%) = €14,019,607
Valuation result
| Year | FCF (€) | Discount factor | Present Value (€) |
|---|---|---|---|
| 1 | 180,000 | 0.9045 | 162,810 |
| 2 | 420,000 | 0.8181 | 343,602 |
| 3 | 438,000 | 0.7399 | 324,072 |
| 4 | 780,000 | 0.6691 | 521,908 |
| 5 | 960,000 | 0.6051 | 580,896 |
| Terminal Value | 14,019,607 | 0.6051 | 8,485,267 |
Enterprise Value: €10,418,555
Interpretation: The sock subscription service has an estimated company value of about 10.4 million euros based on the assumptions made about growth and profitability.
Common mistakes in DCF valuation
Overly optimistic forecasts
Problem: Many analysts overestimate future growth rates and profitability.
Solution: Use conservative estimates and perform sensitivity analyses.
Tip: Compare your growth forecasts with historical industry data and similar companies.
Incorrect WACC determination
Problem: Incorrect assessment of capital costs can lead to significant valuation errors.
Common mistakes:
- Using book values instead of market values
- Ignoring the tax shield of debt
- Incorrect beta estimation
Unrealistic Terminal Value assumptions
Problem: Terminal Value often accounts for 60-80% of total value – small errors have large impacts.
Critical factors:
- Long-term growth rate above economic growth rate
- Unrealistic profitability assumptions
- Ignoring market maturity
Neglecting working capital
Problem: Changes in working capital are often underestimated or ignored.
Especially important for growing companies: Higher revenues usually require proportionally higher inventories and receivables.
Missing sensitivity analysis
Problem: Single point estimates without considering uncertainty.
Solution: Run different scenarios:
- Best Case: Optimistic assumptions
- Base Case: Realistic expectations
- Worst Case: Conservative estimates
Conclusion
DCF valuation is a powerful tool for sound company valuations. It offers a theoretically solid foundation and enables the objective determination of a company’s intrinsic value. As our sock subscription service example shows, the DCF method can provide valuable insights even for innovative business models.
The strength of DCF analysis lies in its transparency and comprehensibility. All assumptions are explicitly stated and can be discussed and adjusted. This makes it an indispensable tool for investors, founders, and consultants.
However, it is important: A DCF valuation is only as good as the underlying assumptions. Careful market analysis, realistic forecasts, and conservative estimates are the key to success.
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