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Updated: Feb 28

If you are thinking of selling your business, you might be wondering how much it is worth. One of the most common and reliable methods to value a business is the discounted cash flow (DCF) analysis. In this blog post, I will explain what DCF analysis is, how it works and why it is useful for SMB owners.

What is DCF analysis?

DCF analysis is a way of estimating the present value of a business based on its expected future cash flows. The idea behind DCF analysis is that a business is worth the sum of all its future cash flows discounted to todayâ€™s dollars.

To perform a DCF analysis, you need to project the future cash flows of your business for a certain period (usually 5 to 10 years) and then discount them using an appropriate discount rate (also known as the weighted average cost of capital or WACC). The discount rate reflects the risk and opportunity cost of investing in your business compared to other alternatives.

The formula for DCF analysis is:

DCF = CF1 / (1 + r) + CF2 / (1 + r)^2 + ... + CFn / (1 + r)^n

Where:

• DCF = discounted cash flow or present value of your business

• CF = cash flow in each year

• r = discount rate or WACC

• n = number of years

How does DCF analysis work?

To illustrate how DCF analysis works, letâ€™s take an example of a hypothetical SMB that sells software products. The SMB has annual revenues of \$10 million and annual expenses of \$8 million, resulting in an annual free cash flow (FCF) of \$2 million. The SMB expects its FCF to grow by 5% per year for the next 10 years. The SMBâ€™s WACC is 10%, which means that it can earn 10% per year by investing in other projects with similar risk and return profiles.

The present value of each yearâ€™s FCF is obtained by multiplying it by the discount factor, which is calculated as 1 / (1 + r)^n. For example, the discount factor for year 1 is 0.909, which means that \$1 received in one year is worth \$0.909 today.

The sum of all the present values gives us the DCF value of the SMB:

DCF = \$13 million

This means that based on our assumptions, the SMBâ€™s software products are worth \$13 million today.

Why use DCF analysis?

DCF analysis has several advantages over other valuation methods such as multiples or transactions:

• It captures the intrinsic value of your business based on its own performance and potential.

• It accounts for the time value of money and risk-adjusted returns.

• It allows you to incorporate different scenarios and sensitivities into your projections.

• It can be applied to any type of business with predictable cash flows.

However, DCF analysis also has some limitations and challenges:

• It requires many assumptions and estimates that may not be accurate or realistic.

• It can be sensitive to changes in inputs such as growth rates or discount rates.

• It can be complex and time-consuming to perform correctly.

Therefore, it is important to use DCF analysis with caution and cross-check your results with other valuation methods and market data.

As an investment banker with extensive experience in M&A transactions, I can help you perform a professional and reliable DCF analysis for your business.