DCF Analysis Explained for Private Companies

What Is a DCF Analysis?

A discounted cash flow analysis is a valuation method that estimates what a business is worth based on the cash it is expected to generate in the future. The fundamental principle is simple: a dollar received tomorrow is worth less than a dollar received today. A DCF model quantifies this by projecting future cash flows and then discounting them back to the present at a rate that reflects the risk of actually receiving those cash flows.

For public companies with abundant market data, DCF analysis is relatively straightforward. For private companies, it requires more judgment and careful estimation, but it remains one of the most rigorous and widely respected valuation methods available. If you are a business owner, investor, or advisor working with private companies, understanding how DCF works is essential.

The Five Key Steps of a DCF Analysis

Step 1: Project Future Free Cash Flows

The foundation of any DCF model is a set of projected free cash flows, typically covering five to ten years. Free cash flow represents the cash available to all capital providers after the business has funded its operations and necessary capital expenditures. The formula is straightforward:

• Start with operating income (EBIT)
• Subtract taxes on operating income
• Add back depreciation and amortization (non-cash charges)
• Subtract capital expenditures
• Subtract or add changes in working capital

For private companies, these projections should be based on normalized financial statements. That means adjusting for above-market owner compensation, one-time expenses, related-party transactions, and other items that do not reflect the ongoing economics of the business.

The projection period should be long enough to capture the period during which the company transitions from its current growth trajectory to a stable, long-term growth rate. For most businesses, five to seven years is sufficient.

Step 2: Estimate the Discount Rate (WACC)

The discount rate reflects the riskiness of the projected cash flows. For a DCF that values the entire enterprise, the appropriate discount rate is the weighted average cost of capital (WACC), which blends the cost of equity and the cost of debt based on the company's target capital structure.

This is where private company DCF analysis gets tricky. Public companies have observable stock prices and bond yields that make calculating WACC relatively mechanical. Private companies do not.

For the cost of equity, most practitioners start with the Capital Asset Pricing Model (CAPM) and then layer on additional risk premiums specific to private companies:

• Risk-free rate: Typically the yield on a long-term government bond
• Equity risk premium: The expected return of the broad stock market above the risk-free rate
• Size premium: Smaller companies historically earn higher returns to compensate for greater risk
• Company-specific risk premium: An adjustment for factors unique to the business, such as customer concentration, key-person dependency, geographic risk, or limited product diversification

For private companies, the total cost of equity often falls in the range of 15% to 30%, significantly higher than for large public companies. The size premium and company-specific risk premium account for much of this difference.

The cost of debt is usually more straightforward. It is the interest rate the company would pay on new borrowings, adjusted for the tax benefit of interest deductions.

Step 3: Calculate Terminal Value

Since you cannot project cash flows indefinitely, a DCF model uses a terminal value to capture all of the value beyond the explicit projection period. Terminal value often represents 50% to 75% of the total enterprise value, which is why getting it right matters so much.

There are two standard approaches:

The perpetuity growth method assumes the business will continue generating free cash flows that grow at a constant rate forever. The formula takes the final year's free cash flow, grows it by one year at the long-term growth rate, and divides by the discount rate minus the growth rate. The long-term growth rate should generally not exceed the expected growth rate of the overall economy, typically 2% to 3%.

The exit multiple method applies a valuation multiple (usually EV/EBITDA) to the final year's projected earnings figure. This approach implicitly assumes that the business could be sold at that multiple at the end of the projection period. The exit multiple should reflect the expected state of the business and industry at that future point in time, not necessarily today's market conditions.

Many practitioners calculate terminal value using both methods and compare the results as a reasonableness check.

Step 4: Discount Everything to the Present

Once you have the projected free cash flows and the terminal value, you discount each back to the present using the WACC. The discounting formula divides each future cash flow by one plus the WACC raised to the power of the number of years until that cash flow is received.

The sum of all discounted cash flows plus the discounted terminal value gives you the enterprise value of the business.

Step 5: Bridge from Enterprise Value to Equity Value

Enterprise value represents the value of the entire business to all capital providers. To arrive at equity value, which is what the owners actually receive, you need to adjust for the company's balance sheet:

• Subtract interest-bearing debt
• Subtract any minority interests
• Add cash and cash equivalents
• Add or subtract other non-operating assets and liabilities

The result is the equity value, which can then be divided by the number of shares outstanding to arrive at a per-share value if needed.

Common Pitfalls in Private Company DCF Analysis

Overly Optimistic Projections

The most pervasive problem in DCF analysis is the hockey stick projection, where revenue and margins suddenly inflect upward in year two or three without a clear, specific justification. Projections should be grounded in historical performance, identified growth drivers, and realistic assumptions about market conditions.

Using the Wrong Discount Rate

Applying a public company WACC to a private company will almost always overstate value. Private companies carry additional risks related to liquidity, size, diversification, and management depth. Failing to account for these risks through appropriate size and company-specific premiums is a common and costly error.

Terminal Value Domination

When terminal value represents more than 80% of total enterprise value, it is a sign that either the projection period is too short or the terminal assumptions need revisiting. A healthy DCF model should derive meaningful value from the explicit projection period, not just from the terminal value assumption.

Ignoring Scenario Analysis

A single-scenario DCF gives you a single number, which creates a false sense of precision. Running the model under multiple scenarios, including a base case, an upside case, and a downside case, reveals how sensitive the valuation is to key assumptions and produces a much more useful range of values.

Inconsistent Assumptions

Growth rates, margin assumptions, capital expenditure requirements, and working capital needs should all be internally consistent. A projection that shows revenue doubling while capital expenditures remain flat, for example, is likely unrealistic.

Making DCF Analysis Practical

DCF analysis is powerful, but its complexity can be intimidating, particularly for private companies where you are estimating inputs rather than observing them in the market. The key is to focus on getting the big assumptions reasonably right rather than striving for false precision on every input.

Tools like ValueAlpha help simplify this process by automating the mechanical aspects of the model while letting you focus on the judgment calls that actually drive value. A well-structured DCF model, combined with scenario analysis and a sanity check against market-based valuation methods, gives you a rigorous and defensible view of what a private company is worth.

The most important thing to remember about DCF analysis is that it is only as good as the assumptions that go into it. Spend your time challenging those assumptions, testing sensitivities, and understanding what drives the result. That is where the real insight lies.