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The method of assessment by discounted cash flows, better known as the method DCF (Discounted Cash Flows)is one of the most widely used tools to determine the real value of a business.
Its principle is simple: a company is worth above all the money it will be able to generate in the future. The method therefore consists of estimating these future cash flows and then "reducing" them to their value today, taking into account the time, Risk and cost of capital.
In other words, a euro that the company will win in five years is not worth as much as a euro immediately available.
This allows for the transformation of a set of financial assumptions: growth, margins, investments, working capital requirements into a coherent and quantified economic value.
The method, which is popularized, is to answer a fundamental question:
How much would you be willing to pay today to get the cash flow that the company will produce tomorrow?
Let us propose a simple step-by-step method for evaluating a company using the Discounted Cash-Flows.
STEP 1 – Understanding the principle of DCF
1.1. Central idea
The value of a business = what it will generate as cash in the future, reduced today.
Why "today"?
Because 1 € Today is worth more than 1 € in 5 years (uncertainty, inflation, opportunity cost).
1.2. Very simple illustration
Suppose:
- You can buy a small business that will bring you back 10 000 € Cash each year for 3 years.
- The minimum return you require for an investment of this type is 10% per year.
Question : How much are you willing to pay today for this business?
We're going to bring each stream back to today, applying a "rebate" (update).
STEP 2 – Concept of updating
2.1. Updating a future flow
If I want a 10% yield per year:
- 1 € Today must become 1,10 € In a year.
- Conversely, 1.10 € in 1 year is worth 1 € Today.
So, to bring a future flow back to today, we use a very simple formula:
Value today = Future amount / (1 + rate)
Example 1 – Single flow
You receive 11,000 € In a year.
Required rate: 10%.
- Value today = 11,000 / 1.10 = 10 000 €.
Example 2 – Several years
You receive 11,000 € In two years.
- Year 1 : 1 → 1.10
- Year 2: 1.10 → 1.10 × 1.10 = 1.21So, 11,000 € in 2 years equals:11,000 / (1.10 × 1.10) = 11,000 / 1.21 9 091 €.
Practical rule:
- the flow is far in time,
- The more he's "raboted" by updating.
STEP 3 – Overview of an evaluation
For a company, the approach is as follows:
- Project Cash Flows (FCFF) over a few years (5-7 years).
- Estimating a terminal value for everything that comes next.
- Update all these flows with a risk-reflecting rate (WACC).
- Get a business value (VE).
- Reduce net debt to reach the value of equity.
STEP 4 – Construction of a simplified business plan
4.1. Starting data (year 0: last year)
Enterprise Alpha Technologies, CA 2024 = 10 M€.
| Post | Amount 2024 |
|---|---|
| Turnover (CA) | 10 000 000 € |
| Operational costs (excluding depreciation) | 8 000 000 € |
| EBIT (operational outcome) | 2 000 000 € |
| Amortization | 500 000 € |
| Income before tax | 1 500 000 € |
| Tax (rate 28%) | 420 000 € |
| Net profit | 1 080 000 € |
BFR 2024 = 1 500 000 €
Net capital assets = 4,000,000 €
CAPEX 2024 = 600,000 €
4.2. Business plan assumptions (2025–2029)
To remain pedagogic, we take simple hypotheses:
- AC growth: 3 % per year.
- Operational Margin (EBIT/CA): 20 % (as 2024).
- Amortization: 0.5 M€ per year (simplified hypothesis).
- Tax rate: 28 %.
- CAPEX: 600,000 € per year.
- BFR: 15% of AC (table in %).
We'll project on 5 years : 2025 to 2029.
STEP 5 – Project the simplified profit and loss account
5.1. Projection table (2025–2029)
| 2025 | 2026 | 2027 | 2028 | 2029 | |
|---|---|---|---|---|---|
| CA (M€) | 10 × 1,03 = 10,30 | 10,30 × 1,03 = 10,61 | 10,93 | 11,26 | 11,60 |
| Marge EBIT | 20 % | 20 % | 20 % | 20 % | 20 % |
| EBIT (M€) | 2,06 | 2,12 | 2,19 | 2,25 | 2,32 |
| Depreciation (M)€) | 0,50 | 0,50 | 0,50 | 0,50 | 0,50 |
| Output before IS (M€) | ≈ 1,56 | ≈ 1,62 | ≈ 1,69 | ≈ 1,75 | ≈ 1,82 |
| IS (28%) (M€) | 0,44 | 0,45 | 0,47 | 0,49 | 0,51 |
| Net result (M)€) | ≈ 1,12 | ≈ 1,17 | ≈ 1,22 | ≈ 1,26 | ≈ 1,31 |
This is not yet cash, but this data will be used to calculate the FCFF.
STEP 6 – Calculation of BFR and CAPEX
6.1. BFR planned
Reminder: BFR = 15% of the AC.
| 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | |
|---|---|---|---|---|---|---|
| CA (M€) | 10,00 | 10,30 | 10,61 | 10,93 | 11,26 | 11,60 |
| BFR (15% of turnover) (M€) | 1,50 | 1,55 | 1,59 | 1,64 | 1,69 | 1,74 |
Change in BFR (ΔBFR) = BFR year N – BFR year N-1
| 2025 | 2026 | 2027 | 2028 | 2029 | |
|---|---|---|---|---|---|
| ΔBFR€) | 1,55 – 1,50 = 0,05 | 1,59 – 1,55 = 0,04 | 1,64 – 1,59 = 0,05 | 1,69 – 1,64 = 0,05 | 1,74 – 1,69 = 0,05 |
One BFR increase consumption of cash, decrease Free.
6.2. CAPEX
Guess. Constant CAPEX of 0.60 M€ per year (investments required).
STEP 7 – Free Cash Flow to Firm calculation
Reminder of the formula:
FCFF = EBIT × (1 – IS) + Amortizations – CAPEX – ΔBFR
IS rate: 28% → (1 – IS) = 72%.
7.1. Calculation year by year (in M€)
Year 2025
- EBIT = 2.06
- EBIT after tax = 2.06 × 0.72
-
- Amortization = 0.50
- – CAPEX = 0.60
- – ΔBFR = 0.05
FCFF 2025 - 1.48 + 0.50 - 0.60 - 0.05 = 1.33 M€
Year 2026
- EBIT = 2.12
- EBIT after tax = 2.12 × 0.72
-
- Amortization = 0.50
- – CAPEX = 0.60
- – ΔBFR = 0.04
FCFF 2026 1.39 M€
The same pattern is followed:
| 2025 | 2026 | 2027 | 2028 | 2029 | |
|---|---|---|---|---|---|
| EBIT (M€) | 2,06 | 2,12 | 2,19 | 2,25 | 2,32 |
| EBIT after IS (×0.72) | 1,48 | 1,53 | 1,58 | 1,62 | 1,67 |
| + Depreciation | 0,50 | 0,50 | 0,50 | 0,50 | 0,50 |
| – CAPEX | 0,60 | 0,60 | 0,60 | 0,60 | 0,60 |
| – ΔBFR | 0,05 | 0,04 | 0,05 | 0,05 | 0,05 |
| FCFF (M€) | 1,33 | 1,39 | 1,43 | 1,47 | 1,52 |
We now have a series of future cash flows.
STEP 8 – Determination of terminal value (VT)
We have flows from 2025 to 2029. But the company does not stop in 2030!
It is therefore necessary to estimate the value for everything that comes after 2029, called terminal value.
8.1. Long-term growth hypothesis
It is assumed that from 2030 :
- Long-term growth of FCFF is moderate, for example 2 % per year.
- This is consistent with a developed economy (low but positive growth).
8.2. Calculation of FCFF 2030
CFFF 2029 is taken and applied to long-term growth.
FCFF 2029 = 1.52 M€
Growth g = 2% → FCFF 2030 = 1.52 × 1.02 1.55 M€
8.3. Terminal value formula
text{VT} = frac{text{FCFF}_{2030}}{text{WACC} – g}
We still miss the WACC ; we will calculate it at the next step, then we will return to the VT with an encrypted example.
STEP 9 – Calculation of discount rate (WACC)
9.1. Simplified market data
It is assumed:
- Risk-free rate (long-term government bond): 2 %.
- Market risk premium: 6 %.
- Company beta (market risk): 1,0 (average risk)
- Cost of pre-tax debt (average borrowing rate): 4 %.
- Rate of IS: 28 % → (1 – IS) = 72%.
- Target structure: 60% equity / 40% debt (market value).
9.2. Capital cost (Ke)
Formula CAPM:
Ke = Rf + β × Hazard pay
Ke = 2 % + 1.0 × 6 % = 8 %
9.3. Cost of post-tax debt
Kd gross = 4 per cent
Net Kd = 4% × (1 – 28%) = 4% × 0.72 = 2,88 %
9.4. WACC calculation
WACC = (E / (D + E)) × Ke + (D / (D + E)) × Kd net
- Own funds share = 60 %
- Share of debt = 40%
WACC = 0.60 × 8 % + 0.40 × 2.88 %
= 4,80 % + 1,15 % ≈ 5,95 %, which will be rounded to 6 %.
We will therefore use WACC = 6 per cent in our example.
STEP 10 – Calculation of terminal value (with WACC)
Let's use the formula:
- FCFF 2030 = 1.55 M€
- WACC = 6 per cent
- g = 2 per cent
text{VT} = frac{1{,}55}{0{,}06 – 0{,}02} = frac{1{,}55}{0{,}04} = 38{,}75 text{ M€}
The terminal value (in 2029, before updating) is therefore 38.75 M€.
STEP 11 – Update flows and terminal value
We're going now reduce all flows (2025–2029) and the VT to today (end 2024), with the WACC of 6%.
11.1. Updating of FCFF
Formula:
Present value = FCFF / (1 + WACC)^t
where t = number of years in the future.
Summary table
| Year | t | FCFF (M€) | Discount factor (1.06*t) | Present value (M)€) |
|---|---|---|---|---|
| 2025 | 1 | 1,33 | 1,06 | 1,33 / 1,06 ≈ 1,25 |
| 2026 | 2 | 1,39 | 1,062 1,124 | 1,39 / 1,124 ≈ 1,24 |
| 2027 | 3 | 1,43 | 1,063 1,191 | 1,43 / 1,191 ≈ 1,20 |
| 2028 | 4 | 1,47 | 1.064 1.262 | 1,47 / 1,262 ≈ 1,16 |
| 2029 | 5 | 1,52 | 1,065 1,338 | 1,52 / 1,338 ≈ 1,14 |
Sum of updated flows (2025–2029) :
1,25 + 1,24 + 1,20 + 1,16 + 1,14 ≈ 6.99 M€.
11.2. Update of terminal value
VT = 38.75 M€ (in 2029).
We have to bring it back to the end of 2024, so update it over five years:
- Factor 1.065
- Present value of the VT = 38.75 / 1.338 28.96 M€
11.3. Business value (VE)
VE = Sum of updated FCFF + updated VT
VE 6.99 + 28.96 35.95 M€
It is possible to round to 36 M€ for Alpha Technologies.
STEP 12 – From enterprise value to equity value
Suppose that at the valuation date:
- Gross financial debt = 8 M€.
- Cash and cash investments = 2 M€.
Net debt = 8 – 2 = 6 M€.
Value of equity = VE – Net debt
= 36 – 6 = 30 M€
If the company has for example 1 million shares in circulation:
Value per share = 30 M€ / 1 M = 30 € by action
STEP 13 – Sensitivity to assumptions
The DCF is Very sensitive To:
- long-term growth (g),
- the WACC.
13.1. Example: variation of g
WACC = 6%, VE recalculated only by changing g.
- Prudent scenario: g = 1%
- FCFF 2030 = 1.52 × 1.01 €
- VT = 1.54 / (0.06 – 0.01) = 1.54 / 0.05 = 30.8 M€
- Updated TV €
- VE 6.99 + 23.0 30.0 M€
- Value of equity 24 M€
- Optimistic scenario: g = 3%
- FCFF 2030 = 1.52 × 1.03 €
- VT = 1.57 / (0.06 – 0.03) = 1.57 / 0.03 €
- Up-to-date TVs - 52.3 / 1.338 - 39.1 M€
- VE 6.99 + 39.1 46.1 M€
- Value of equity 40.1 M€
Educational conclusion:
Just changing g from 1 % to 3 %, the value of equity passes by around 24 M€ 40 M€.
We must therefore be extremely careful and documented on this parameter.
13.2. Example: WACC variation
We go back with g = 2% and we vary the WACC from 5% to 7%.
- At WACC = 5 per cent, the value increases (flow minus "raboted").
- At WACC = 7%, the value drops.
Impact of WACC variation on business value (VE)
Constant assumptions: FCFF 2029 = 1.52 M€, FCFF 2030 = 1.55 M€, g = 2 %.
| WACC | Terminal value (VT) before discount | Discount factor(1 + WACC)^5 | Updated VT | Sum of updated FCFF (2025–2029) | Business value (VE) | Value of equity (VE – net debt of 6 M€) |
|---|---|---|---|---|---|---|
| 5 % | FCFF2030 / (WACC – g) = 1.55 / (0.05 – 0.02) = 51.67 M€ | 1,05^5 = 1,276 | 51,67 / 1,276 = 40.49 M€ | 7.34 M€ | 47.83 M€ | 41.83 M€ |
| 6% (central scenario) | 1,55 / (0,06 – 0,02) = 38.75 M€ | 1,06^5 = 1,338 | 38,75 / 1,338 = 28.96 M€ | 6.99 M€ | 35.95 M€ | 29.5 M€ |
| 7 % | 1,55 / (0,07 – 0,02) = 31.00 M€ | 1,07^5 = 1,403 | 31,00 / 1,403 = 22.09 M€ | 6.67 M€ |
- When WACC declines to 5%, future flows are "less penalized" →the value rises sharply (VE 48 M€, equity €).
- When WACC increases to 7%, we consider the company to be more risky →value drops sharply (VE 29 M€, equity €).
- The central scenario 6 % logically lies between the two.
Conclusion: The DCF method is extremely sensitive to the WACC, as any change in the rate has a strong impact on the terminal value, which often represents 60-80% the total value.
Conclusion
The updated cash flow method (DCF) is one of the foundations of modern financial valuation. By focusing on the company's future ability to generate cash, it places value creation at the heart of the process. Its conceptual rigour, its logical articulation between operational performance, investment needs, financing structure and risk perception make it a powerful tool to understand what really makes a business worth.
However, this power is based on a requirement: quality of assumptions. A DCF is never more reliable as the business plan behind it and the relevance of the discount rate chosen.
Projected margins, future investments, the evolution of the BFR or the long-term growth rate must be coherent, well-founded and explicit. Similarly, the high sensitivity of the final value to some critical parameters requires caution, transparency and critical approach.
The evaluator must never have an "absolute" value, but a argumented range, based on reasonably probable scenarios.
As robust as it is, the DCF method alone is not enough. In professional practice, reliable assessment is always based on a multi-criteria approach. FCEs need to be confronted with other methods in order to achieve a balanced vision and strengthen the credibility of the conclusion:
- Analog methods (multiple stock exchanges, multiple transactions), which provide an immediate benchmark based on market behaviour.
- Heritage methods, relevant in sectors where the value of assets exceeds the future capacity to generate cash, or where a floor value has to be measured.
- Methods based on real options, useful for integrating strategic flexibility, especially in innovative or highly uncertain sectors.
This articulation between several approaches not only validates the results achieved, but also enriches the strategic and financial analysis. The value of a company is never a figure obtained by a formula: it emerges from a coherent set of assumptions, comparisons, sectoral analyses and professional judgments.
Appendix: Explanatory table of technical terms of the DCF method
| Technical term | Clear definition | Role in the DCF method | Simple illustration |
|---|---|---|---|
| DCF (Discounted Cash Flows) | Assessment method based on updating future cash flows. | Determines the economic value of a business through its ability to generate cash. | « How much is the money the company will earn tomorrow? » |
| Cash Flow | Money actually generated by activity, after current expenditure. | This is the basis of valuation. | A company wins 100 €expenditure 60 €, 40 left € It's his cash flow. |
| FCFF (Free Cash Flow to Firm) | Cash flow available for all financiers: shareholders + lenders. | This is the flow used to assess enterprise value (VE). | Cash available before debt payment. |
| FCFE (Free Cash Flow to Equity) | Cash flow available only for shareholders. | Allows you to calculate the value of own funds directly. | Cash available after paying interest and repaying debt. |
| Update | Operation of reducing a future amount to its present value. | Allows time and risk to be considered. | 110 € in a year worth 100 € today if the discount rate is 10%. |
| Discount rate | Rate used to convert a future flow to present value. | The higher it is, the less "valent" future flows today. | At 15%, a flow of 1,000 € in 3 years is worth much less than 5%. |
| WACC (Weighted Average Cost of Capital) | Weighted average cost of capital: return expected by shareholders and creditors. | This is the main discount rate for FCFF. | If shareholders want 8% and lenders 4%, the WACC is in between. |
| Capital cost (Ke) | Return required by shareholders to finance the company. | Major component of the WACC. | A shareholder often requires 8 to 12% depending on risk. |
| Cost of debt (Kd) | Average cost of loans contracted by the enterprise. | Include tax deductible interest. | A business borrows at 4%: after tax, it can cost 3%. |
| CAPM (Capital Asset Pricing Model) | Economic model for calculating the cost of equity. | Used to determine Ke in DCF. | Ke = risk-free rate + beta × hazard premium. |
| Risk-free rate (Rf) | Interest rate offered by a risk-free asset (e.g. government bonds). | Starting point of the Ke calculation. | OAT 10 years French: ~2-3%. |
| Market risk premium | Increased returns required by investors to accept equity risk. | Multiplyed by beta in CAPM. | Historically between 5% and 6% in Europe. |
| Beta (β) | Measurement of a company's risk to the market. | The higher the beta, the higher the ke. | β = 1: risk identical to the market; β = 2: twice as risky. |
| Target financial structure | "ideal" distribution between debt and equity. | Used to calculate the WACC. | 60% equity / 40% debt. |
| EBIT (Earnings Before Interest and Taxes) | Operating income before interest and taxes. | Basis for calculating after-tax flows (NOPAT). | Company gains 2 M€ before financial charges and taxes. |
| NOPAT (Net Operating Profit After Tax) | Operating income after theoretical tax. | CFFF starting point. | EBIT = 1 M€, IS = 30 % → NOPAT = 0.7 M€. |
| Amortization | Undisbursed charges reflecting wear and tear of assets. | Added to the streams because they don't cost cash. | Machine purchased 100 k€ amortised 10 k€/year: no cash exit. |
| CAPEX (Capital Expenditure) | Investments necessary to maintain or develop activity. | Subtract the flows because they consume cash. | Purchase of a machine, modernisation of a site. |
| BFR (Need in Rolling Fund) | Money locked in inventory, receivables, supplier debts. | Change in BFR = consumption or cash generation. | If stocks increase, cash decreases. |
| ΔBFR | Change in BFR from year to year. | Enter the calculation of the FCFF. | BFR increases from 100 to 120: ΔBFR = +20 (cash consumption). |
| Explicit Horizon | Detailed forecast period (usually 5-7 years). | Allows to project flows reliably. | Forecast CA, margins, CAPEX, BFR... |
| Terminal value (VT) | Value of all flows generated after the explicit horizon. | Often represents 60–80 % of the total value. | Estimated via perpetual growth (g) or multiple. |
| Long-term growth rate (g) | Expected growth after the forecast period. | Used to calculate the VT. | Mature economy: g 1 to 2%. |
| Gordon-Shapiro Formula | Model to calculate VT with g. | VT = FCFFn+1 / (WACC – g). | If FCFF = 1 M€, WACC=8%, g=2%, VT = 1 / 0.06 = 16.7 M€. |
| Business value (VE) | Total value available for all financiers. | Direct result of the DCF method. | VE = sum of updated flows + VT updated. |
| Net debt | Financial debt – cash available. | Allows to switch from VE to the value of equity. | Debts = 8 M€, cash = 2 M€ → net debt = 6 M€. |
| Value of equity | Economic value to shareholders. | Last step of the calculation. | VE = 36 M€, net debt = 6 M€ → equity = 30 M€. |
| Sensitivity Analysis | Analysis of the effect of a change in hypothesis (WACC, g...). | Allows to evaluate the robustness of the value. | If WACC increases from 6% to 7%, the value drops sharply. |
| Football field | Graph comparing the values obtained by different methods. | Visualization of the value range. | Horizontal bar showing DCF, multiple, ANR, etc. |
| Multi-criteria approach | Combination of several assessment methods. | Confirms or nuances the result of the DCF. | DCF + comparable + heritage. |
| Goodwill | Value paid on acquisition. | Calculated by comparing paid price with net asset value. | Price 100 M€, net assets 70 M€ → goodwill 30 M€. |
