Income Approach
The DCF method values a business by projecting its future free cash flows over a forecast period (typically 5 years), estimating a terminal value for all years beyond, and discounting everything back to present value using a risk-adjusted discount rate. It's the most theoretically rigorous method — and the most sensitive to assumptions.
Under USPAP Standard 9, the DCF method is a yield capitalization technique that projects multiple periods of future earnings and discounts them to present value. Unlike direct capitalization (Cap of Earnings), DCF explicitly models changes in cash flows over a projection period, making it more appropriate when earnings are expected to change materially. USPAP requires that projections be based on reasonable and appropriate evidence, and that the appraiser explain and support the basis for growth assumptions, discount rate components, and terminal value methodology.
Standards references: USPAP Standard 9, Duff & Phelps/Kroll Build-Up Method, Gordon Growth Model, NACVA DCF Standards, Shannon Pratt's Cost of Capital
Starting from normalized historical earnings, project free cash flows for each year of a 5-year forecast period. Adjust for expected revenue growth, margin changes, capital expenditures, and working capital requirements. FCF = Net Operating Income − Capital Expenditures ± Changes in Working Capital.
Build the discount rate using the Build-Up Method: Risk-Free Rate + Equity Risk Premium + Size Premium + Industry Risk Premium + Company-Specific Risk Premium (CSRP). For small private businesses, discount rates typically range from 20% to 35%. The CSRP is derived from the 15-factor risk analysis scored by the broker.
Terminal value captures the business's worth beyond the 5-year forecast period and typically represents 60–80% of total value. Two approaches are used: the Gordon Growth Model (FCF Year 5 × (1 + g) ÷ (r − g)) and the Exit Multiple Method (Year 5 EBITDA × exit multiple). MainStreetOS™ uses a blended average of both methods.
Each projected cash flow and the terminal value are discounted back to today using the formula: PV = FCF ÷ (1 + r)^n, where r is the discount rate and n is the year number. Sum all present values to arrive at the indicated business value.
Business Value = Σ [FCFₙ ÷ (1 + r)ⁿ] + [Terminal Value ÷ (1 + r)⁵]
Sum of discounted future cash flows (Years 1–5) plus discounted terminal value
Gordon Growth Terminal Value
TV = FCF₅ × (1 + g) ÷ (r − g)
where g = long-term sustainable growth rate
Exit Multiple Terminal Value
TV = Year 5 EBITDA × Exit Multiple
where Exit Multiple reflects expected sale conditions
Terminal value typically accounts for 60–80% of the total DCF valuation. This means small changes in the long-term growth rate or exit multiple have an outsized impact on the final number. This is why MainStreetOS™ uses a blended approach — averaging the Gordon Growth and Exit Multiple methods to cross-validate and reduce the impact of any single assumption.
A 1-percentage-point change in the discount rate can shift the total valuation by 10–20%. A fractional increase in the perpetual growth rate can materially increase terminal value. This is why DCF results should always be cross-validated against Market Multiple and Cap of Earnings conclusions.
Agent 3 executes the DCF method by:
The appraiser must base estimates of capitalization rates and projections of future earnings capacity on reasonable and appropriate evidence. Projections must weigh historical information and trends, current market factors, and reasonably anticipated events. The terminal value methodology and long-term growth assumption must be explained and supported.
For small private businesses, discount rates typically range from 20% to 35%, substantially higher than the 8-10% applied to large public companies. Failing to apply an appropriate size premium is one of the most common errors in small business DCF models. The company-specific risk premium (CSRP) accounts for risks unique to the subject business.
Terminal value typically accounts for 60-80% of total DCF valuation. The perpetual growth rate must not exceed long-term GDP growth (typically 2-3%). Using both the Gordon Growth Model and Exit Multiple method, then blending results, is considered best practice by NACVA and ASA practitioners.
The analyst must clearly state and support all significant projections and assumptions. Year 1 of projected cash flows is the year following the valuation date. A sensitivity analysis showing the impact of key assumption changes on value is strongly recommended for defensibility.
Using an unrealistically high revenue growth rate unsupported by historical performance; applying a discount rate too low for a small private company; omitting required capex from FCF calculations; using a terminal growth rate exceeding long-term GDP growth; failing to reconcile DCF against market multiples.
MainStreetOS™ builds your discount rate from 15 risk factors, projects 5-year cash flows, and blends two terminal value methods.
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