Key Insight
DCF is theoretically correct and practically unreliable for small businesses. The inputs — growth rate, discount rate, terminal value — are speculative enough that the output is often garbage dressed up in math.
How DCF Works
- Project free cash flows: Forecast the business's FCF for 5-10 years
- Determine discount rate: Apply a risk-adjusted rate (WACC or required return) to account for time value of money and business risk
- Calculate terminal value: Estimate the value of all cash flows beyond the projection period (usually as a perpetuity or exit multiple)
- Discount to present value: Sum all projected FCFs and terminal value, discounted at the discount rate
Why DCF Is Rarely Used for SMB Acquisitions
For large, publicly traded companies or PE-backed businesses with professional finance functions, DCF is a reasonable tool. For SMBs under $5M in revenue:
- Cash flow forecasting is speculative: A 3-year-old HVAC company with $280K SDE doesn't have the data to reliably project 10-year cash flows
- Discount rate is arbitrary: SMB discount rates should reflect illiquidity, small-company risk, and single-operator risk — but quantifying these is more art than science
- Terminal value dominates: In most DCF models, 60-80% of the value is in the terminal value, which is just a multiple applied to a projected number
In practice: SMB acquisitions are priced primarily on SDE or EBITDA multiples derived from comparable transactions — what similar businesses actually sold for.
When DCF Is Useful
DCF is useful as a sanity check: if a multiple-based valuation produces a price that implies a 3% annual return on a DCF basis, that's a signal something is wrong with the multiple or the earnings estimate.
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