In the UK, discounted cash flow turns up in three familiar rooms. A trade buyer’s model. A shareholder dispute where “maintainable earnings times a multiple” has already been shouted across a table. And a lender’s credit paper, where the cash that services debt matters more than a hopeful exit year. The method is not exotic. It is a forecast, a rate, and a refusal to hide the terminal value.
What the method is answering
Enterprise discounted cash flow, the version this essay uses, asks what the operations are worth to all providers of capital before you worry about the loan. You forecast free cash flow to the firm, discount it at the weighted average cost of capital, and only then bridge from enterprise value to equity by subtracting net debt.
Free cash flow to equity, discounted at the cost of equity alone, is a legitimate alternative when the debt is peculiar or about to be refinanced into a known shape. It is easier to misuse, because leverage and the cash flows move together. For a stable fictional SME we stay with the firm-level version.
The classroom company
Porth Engineering Ltd is invented. It is a precision fabricator with a workshop, a bank loan, and no drama except the ordinary drama of a 30-person UK manufacturer. The base year, just reported, looks like this.
| Base year | £ |
|---|---|
| Revenue | 4,800,000 |
| EBITDA | 720,000 |
| Depreciation | 180,000 |
| EBIT | 540,000 |
| Corporation tax at 25% | 135,000 |
| NOPAT | 405,000 |
| Add depreciation | 180,000 |
| Less maintenance capital expenditure | 160,000 |
| Less increase in working capital | 40,000 |
| Free cash flow to the firm | 385,000 |
The tax line uses the UK main rate of corporation tax, 25 per cent, which is the right illustrative rate for a company of this profit. A company with very small profits can face a lower rate and marginal relief. Porth is not that company, and this essay is not a tax return.
Notice what is not in the cash flow. Interest is not deducted. The tax is computed on EBIT, not on profit after interest. That is deliberate. The discount rate, below, already charges the operations for the cost of debt after the tax shield. Deducting interest in the cash flow as well would charge debt twice.
Five years, then a grown-up terminal value
Revenue and margins are not modelled line by line here. The essay grows free cash flow itself, which is honest only if you believe margins, tax and reinvestment stay in proportion. They often do not. A real model would forecast revenue, margin, tax, capex and working capital separately, then let cash flow fall out. For a classroom table, a stated growth path is enough, provided you can say it out loud.
The path used is 6 per cent, then 5, 4, 3.5 and 3 per cent. It fades. It does not “hockey stick”. Each year’s cash flow is the prior year grown by that rate, rounded to the pound.
| Year | Growth | FCFF £ | Factor at 11.50% | Present value £ |
|---|---|---|---|---|
| 1 | 6.0% | 408,100 | 0.8969 | 366,024 |
| 2 | 5.0% | 428,505 | 0.8044 | 344,689 |
| 3 | 4.0% | 445,645 | 0.7214 | 321,480 |
| 4 | 3.5% | 461,243 | 0.6470 | 298,424 |
| 5 | 3.0% | 475,080 | 0.5803 | 275,689 |
| Present value of the explicit forecast | 1,606,306 | |||
The factors are 1 divided by 1.115 raised to the year, shown to four decimal places. Present values are the cash flow times that displayed factor, rounded to the pound, so a reader can check the row without a hidden spreadsheet. A mid-year convention, which assumes cash arrives halfway through the year, would increase values slightly. This table uses end-of-year discounting because it is easier to audit.
The terminal value, shown in full
After year five the model does not pretend to know each year. It uses a Gordon growth perpetuity. Year-six cash flow is year five grown at 2 per cent: 475,080 times 1.02 is 484,582. Divide by the cap, which is the discount rate minus that growth: 0.1150 minus 0.0200 is 0.0950. 484,582 divided by 0.0950 is 5,100,863. That sum sits at the end of year five, so it is discounted on the year-five factor: 5,100,863 times 0.5803 is 2,960,031.
Enterprise value is 1,606,306 plus 2,960,031, which is 4,566,337. About 65 per cent of the enterprise value is the terminal value. That is normal, and it is also the sentence you should say in the meeting. If you cannot defend the 2 per cent growth or the 11.50 per cent rate, you do not have a valuation. You have a perpetuity with a costume.
Why 2 per cent? It is a nominal long-run assumption near the Bank of England’s inflation target, with roughly no real growth, which is a sober picture of a mature local fabricator. It is below the discount rate, as it must be or the formula breaks. It is not a forecast of the UK economy and not a promise to Porth’s fictional shareholders.
Where 11.50 per cent came from
A weighted average cost of capital blends the return equity holders require with the after-tax cost of debt, using target weights rather than whatever the last loan statement happens to show. Circularity is real: the weights should be at market value, and market value is what you are solving for. Target weights are the practical way through, and they should be stated.
| Build of the rate | Illustrative |
|---|---|
| Risk-free reference | 4.50% |
| Beta | 1.25 |
| Equity risk premium | 5.00% |
| Size and specific-risk premium | 2.10% |
| Cost of equity | 12.85% |
| Pre-tax cost of debt | 8.00% |
| After tax at 25% | 6.00% |
| Target weight, equity / debt | 80 / 20 |
| Weighted average, unrounded | 11.48% |
| Rate used in the factors | 11.50% |
Check the blend: 0.80 times 12.85 is 10.28, and 0.20 times 6.00 is 1.20. Together, 11.48 per cent, rounded to 11.50 for the discount factors. The risk-free reference is an illustrative gilt-like yield, not a quote from a particular morning. The beta is not taken from a listed peer set in this essay; a real file would show the peers and the de-levering. The 2.10 point premium is where a small, owner-dependent workshop pays for risks that a diversified shareholder of a listed group does not carry one at a time. If you drop that premium because it feels judgemental, say so. Do not bury it.
From enterprise value to the shareholder
Porth’s bank loan is 710,000. Cash is 90,000. This illustration treats the whole cash balance as surplus, because working capital needs are already in the cash-flow forecast rather than trapped inside the cash figure. Net debt is therefore 620,000. Equity value is enterprise value minus net debt: 4,566,337 minus 620,000 is 3,946,337.
The mistake that keeps reappearing in owner-prepared models is to subtract “debt” of 620,000 and then add the cash again. If the 620,000 was already net of cash, the cash has been counted twice and the equity value is flattered by 90,000. Climebit’s worked cases put this equity figure beside a comparables result and an asset floor, and do not average them.
Where DCF misbehaves
- A terminal growth rate that sits close to the discount rate. The denominator collapses and the value becomes a mood.
- Capital expenditure set below depreciation forever, which silently assumes the workshop will fade while the cash keeps arriving.
- A forecast that includes the buyer’s synergies, then a discount rate that does not include the risk of achieving them. That pattern is discussed again under precedent transactions.
- Using a start-up’s hoped-for year-five margin as if the path to it were free of extra cash burn.
- One decimal place of false confidence. 3,946,337 is the arithmetic of the assumptions. It is not more precise than the 2 per cent and the 11.50 per cent that dominate it.
A sensible sensitivity, not a cloud of numbers
Move only the two assumptions that carry the terminal value. If the discount rate is 12.50 per cent and long-run growth stays at 2 per cent, the cap becomes 0.1050 rather than 0.0950, and both the explicit present values and the terminal value fall. If growth is 1 per cent and the rate stays at 11.50 per cent, year-six cash flow is smaller and the cap widens to 0.1050 as well. You do not need a twenty-cell table to see the point. Value lives in that cap. Publish the cap.
Discounted cash flow is the right primary method when the business has a forecast you are prepared to own, year by year, and when a multiple would only be a disguised version of the same hope. It is the wrong primary method when the forecast is weather, a single contract, or a story about a buyer who has not yet appeared. For those, read market comparables and the guest-house case.