The DCF model is an income-based valuation model, where the value of a business, an asset, or a business project is calculated as the discounted value of the expected future, free cash flows attributable to that specific subject of valuation. Unlike the EBITDA multiple method, which starts from historical accounting figures, the DCF method looks forward and builds the value directly on the business's expected future earning power.

How does the DCF model work in practice?

The DCF model is built on three key steps that together translate a future business plan into a present-day krone value.

1. Forecasting future cash flows

First, an estimate is made of how much free cash flow the business is expected to generate year by year over a given forecast period — typically 5–10 years. This requires a realistic estimate of future revenue, costs, investment needs and working capital.

2. Discounting with WACC

A krone in five years isn't worth the same as a krone today. The future cash flows are therefore discounted using a discount rate — most often WACC (Weighted Average Cost of Capital), which reflects the weighted average cost of the business's equity and debt. The higher the risk, the higher the WACC, and the lower the present value of the future cash flows.

3. Terminal value

After the specific forecast period, a terminal value is calculated, representing the present value of all cash flows the business is expected to generate after that. The terminal value often makes up a large — sometimes the largest — share of the total DCF value, so the assumptions behind it should be scrutinized closely.

What is WACC, and how is it calculated?

WACC is the weighted average cost of capital and combines the cost of equity and debt (after tax), weighted by their share of the business's total capital structure. A simplified example: if equity makes up two-thirds of the capital at a return of 10%, and debt makes up one-third at an interest rate of 5% (after a 25% tax shield), WACC becomes: (2/3) × 10% + (1/3) × 5% × (1 − 0.25) ≈ 6.25%. This rate is then used to discount the business's future cash flows.

When does the DCF method make the most sense?

The DCF method is particularly relevant for businesses with a clear, credible growth plan, where historical accounting figures don't capture the full future value — e.g. businesses in strong growth, or businesses facing a major strategic change. The method is often used to supplement the EBITDA multiple method for larger deals, where a single method rarely gives a complete picture alone.

Pros and cons of the DCF model

Pros

  • Directly accounts for the business's future earning power, not just its history
  • Well suited to businesses in growth or with planned strategic changes
  • Provides a transparent, assumption-based calculation that can be discussed and adjusted

Cons

  • Very sensitive to the assumptions used — particularly growth rate and WACC
  • Requires a solid operating budget and a realistic business plan to be meaningful
  • More theoretically demanding than the multiple method, and therefore less often used alone for smaller deals

DCF versus the multiple method — what's the difference?

While the multiple method is quick to use and based on comparable deals in the market, the DCF method requires a detailed business plan and several assumptions about the future. In return, the DCF method better captures the value in a business with a clear growth plan that hasn't yet fully shown up in the accounting figures. In practice, professional advisors often use both methods side by side as a cross-check against each other — read more in our full guide to business valuation, where we also cover the asset-based method and the 10 factors that affect price the most.

Considering listing your business for sale? Try our free valuation tool, or book a free call about a more thorough valuation that can also incorporate the DCF model. Related to the DCF model is also the EVA model, which values a business based on its excess return above the cost of capital.

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