When someone puts a price tag on a business, how do you know if it's fair? The seller will always tell you it's a great deal. The broker will show you impressive-looking charts. But there is a way to cut through all of it with one question: what are the future cash flows of this business actually worth in today's money?
This is called a discounted cash flow analysis — DCF for short — and you do not need to be an accountant to run one. The idea is straightforward: any business is worth the sum of all the cash it will ever produce, adjusted for the fact that money today is worth more than money in the future. That adjustment is what the word "discounted" means.
The three numbers you need
You only need three inputs: the annual free cash flow the business generates, a growth rate, and a discount rate.
Free cash flow is not the same as profit. It is what is left after the business pays all its costs, its taxes, and any investment needed to keep it running. A shop with $80,000 in operating profit might only generate $50,000 in real free cash once you account for equipment replacement and working capital needs. Ask for the actual cash flow number, not the headline profit figure.
The growth rate is your honest estimate of how quickly the business will grow. A stable dry-cleaning shop might grow at 3% per year. A marketing agency winning new clients might grow at 12%. Do not use the seller's projections — use the business's own three-year history and comparable businesses in the same industry.
The discount rate is the return you need to justify the risk. For a small private business, 15 to 20% is typical. This reflects the fact that owning a single small business is far riskier than owning a diversified portfolio of index funds. A lower discount rate increases the calculated value; use one that genuinely reflects the risk you are taking on.
A worked example
A café is listed for $280,000. It generates $45,000 per year in free cash flow and has grown about 5% per year for three years. You require a 16% return. Running a five-year DCF with a terminal value gives a fair value of approximately $310,000. The asking price of $280,000 is below fair value at your required return. That is worth pursuing.
If the asking price were $400,000, the same calculation shows you would be overpaying. You could either negotiate the price down, or revisit whether a 16% discount rate is appropriate — perhaps the business has long-term contracts and lower risk than you assumed.
What about the earnings multiple method?
Many business brokers value businesses using a multiple of earnings — typically two to five times annual profit for small businesses. This is faster and common in practice, but a multiple is really just a DCF with specific assumptions baked in. A four-times multiple implies roughly a 12–15% discount rate and moderate growth. Knowing this lets you assess whether the multiple being asked is generous or miserly for the particular business.
The most reliable approach combines both methods: check the asking price against the DCF, then also compare it to what similar businesses have actually sold for recently. When both methods point to the same number, you have real confidence.
Questions to ask before you buy
- Is the cash flow dependent on the current owner's personal relationships? It may evaporate when they leave.
- Does one customer account for more than 20% of revenue? That concentration risk should raise your discount rate.
- Does the business need significant reinvestment to grow, or does cash flow freely with minimal capital?
- Has the growth rate been consistent, or was one year unusually good?
Use the DCF calculator below to run the numbers. Adjust the discount rate upward for each risk you identify. If the fair value still exceeds the asking price after stress-testing your assumptions, you may have found a genuine opportunity.