Valuation basics: DCF, comparables and precedent transactions

What is a business worth? The honest answer is a range, not a number. Professional valuers rarely rely on one method. They build a value from expected cash flows, check it against what similar companies trade for, and check it again against what buyers have paid for similar businesses. Where the three overlap is usually where a sensible price sits.

This guide explains the three standard methods (discounted cash flow, comparable companies and precedent transactions), how each one works, and how to read the results together. It is written for founders and early-career analysts who need to understand a valuation, not for specialists building one for a court or a takeover panel.

Enterprise value and equity value

First, be clear what you are valuing. Enterprise value (EV) is the value of the whole business, regardless of how it is financed. Equity value is what belongs to shareholders.

To move from one to the other, subtract net debt: equity value = enterprise value minus debt plus cash. A business worth £8m with £2m of debt and £0.5m of cash has an equity value of £6.5m. Many disagreements in sale negotiations come from people quoting one figure while the other side hears the other.

Discounted cash flow: intrinsic value

A discounted cash flow (DCF) values a business by forecasting the cash it will generate and discounting that cash back to today. It asks what the business is worth on its own merits, regardless of market mood.

1. Forecast free cash flow, usually for five years (sometimes ten). Free cash flow is cash from operations after tax, minus capital spending and the cash tied up in working capital.
2. Choose a discount rate. For enterprise value this is normally the weighted average cost of capital (WACC), which blends the cost of equity and the after-tax cost of debt.
3. Estimate a terminal value for all the years after the forecast. The perpetuity growth method uses next year’s cash flow divided by (discount rate minus long-term growth rate). The exit multiple method applies a multiple, such as EV/EBITDA, to the final year.
4. Discount the forecast cash flows and the terminal value to today and add them up.

The strength of a DCF is that it forces you to state your assumptions about growth, margins and investment. Its weakness is sensitivity. Small changes in the discount rate or growth rate move the answer a lot, and the terminal value often makes up most of the total. The long-term growth rate also needs care: a business cannot grow faster than the wider economy forever, so keep it modest.

Comparable companies: what the market pays today

Comparable company analysis (trading comps) values a business by looking at how the stock market prices similar listed companies. You calculate a multiple for each peer and apply it to your company’s figures.

Common multiples include:

• EV/EBITDA: enterprise value divided by earnings before interest, tax, depreciation and amortisation. Widely used because it ignores differences in debt and depreciation policy.
• P/E: share price divided by earnings per share. An equity multiple, unusable when earnings are negative.
• EV/Sales: useful for loss-making or early-stage businesses, though crude, because sales alone do not create value.

The method is quick and grounded in real prices. Its weaknesses are finding true peers (similar size, growth, margins and market), differences in accounting, and the risk that the whole sector is mispriced. Listed company prices also reflect small, minority stakes, so they include no premium for control.

Precedent transactions: what buyers have paid

Precedent transaction analysis looks at prices paid in past acquisitions of similar businesses and applies the same multiples. Because a buyer acquiring a whole company gains control, these prices usually include a control premium. Typical control premiums are often cited at around 20% to 40% over the market price, so precedent multiples tend to sit above trading multiples.

This method is the closest match when you are actually selling a business. Its weaknesses are that deal data can be thin for small private companies, older deals reflect different market conditions, and each deal has its own circumstances, such as a buyer expecting large cost savings.

A worked example

An example (illustration only): a profitable private business has EBITDA of £1.0m this year and £1.5m of net debt.

DCF. Forecast free cash flow for the next five years is £600k, £660k, £720k, £770k and £810k. With a WACC of 12% and long-term growth of 2.5%, the terminal value is £810k multiplied by 1.025, divided by (12% minus 2.5%), about £8.74m. Discounting everything back:

The terminal value is about two-thirds of the total. Moving WACC between 11% and 13% gives a range of about £6.75m to £8.39m.

Comparables. Similar listed businesses trade at 6 to 8 times EBITDA, implying £6.0m to £8.0m.

Precedents. Recent acquisitions of similar companies were priced at 8 to 10 times EBITDA, implying £8.0m to £10.0m.

Laid side by side (analysts call this a football field chart), the DCF and the trading comparables overlap between about £6.75m and £8.0m, and the top of the DCF range reaches into the precedent range. A reasonable central range is about £7m to £8.4m. For a full sale, the precedents support a price towards the top of that range. After subtracting £1.5m of net debt, the equity value is roughly £5.5m to £6.9m.

Common mistakes

• Mixing enterprise and equity measures, such as applying a P/E multiple to EBITDA.
• Using adjusted EBITDA for your company but reported EBITDA for peers. Make the adjustments consistent.
• Choosing peers that look similar by industry label but differ in growth or margins.
• Setting a long-term growth rate above the long-run growth of the economy.
• Presenting a single precise figure. A valuation to the nearest pound suggests accuracy that does not exist.

When to use each method

Use a DCF when the business has reasonably predictable cash flows and you want to understand what drives value. It is less reliable for early-stage startups with little history or for very cyclical businesses.

Use trading comparables when good listed peers exist and you want a market check. Use precedent transactions when you are buying or selling a whole company and deal data is available.

For most real decisions, use all three, explain why they differ, and present a range. The conversation about why the methods disagree is often more useful than any single number they produce.