Decoding the DCF: The Benchmark Valuation Method

What Is Discounted Cash Flow (DCF)?

The DCF is a valuation method that calculates the present value of the future cash flows a company is expected to generate. The basic premise is that a company is worth the amount of cash it can generate for its investors, brought back to today. The approach reflects the time value of money — a euro today is worth more than a euro in the future — and assumes that an investor will transact when each euro invested grows annually at a rate equal to or above their required return.

Two equivalent approaches: valuing the equity or valuing the firm

In building the model, two routes coexist that, when correctly applied, lead to the same point:

• Equity approach (FCFE → Ke): the free cash flow to equity is discounted at the required return on equity (cost of equity, Ke), yielding the Equity Value directly.
• Firm approach (FCFF → WACC): the unlevered free cash flow is discounted at the weighted average cost of capital (WACC), yielding the Enterprise Value. This is the dominant approach in M&A because it isolates operating cash generation from the financing structure.

The two flows are linked algebraically through the change in net debt and the tax shield on interest: free cash flow to equity equals unlevered free cash flow plus the net increase in debt minus after-tax interest. With consistent assumptions, both methods return the same value; discrepancies usually betray an error in the debt or discount-rate assumptions.

How Is the DCF Performed?

1) Projecting the Cash Flows

The first step is to estimate the company's future cash flows over a specific period, generally five to ten years. The projection horizon will vary with the company's cyclicality and growth outlook: a business with stable, recurring revenues warrants a shorter explicit horizon, which increases the weight of the Terminal Value within the valuation.

These projections rest on the company's historical performance, as well as on growth expectations, operating margins, investment in working capital and fixed assets, and other economic and sector factors.

• The importance of the Business Plan: a detailed, realistic business plan is essential to project future cash flows. It maps out how the company plans to generate revenue, manage costs, invest in growth and compete in its market.
• Free Cash Flow (FCF): FCF represents the cash available to shareholders and lenders after investment in working capital and fixed assets, showing the company's real operating cash generation. Using FCF lets the analyst set the capital structure aside, isolating operating cash generation from financing movements.
• Calculating the discount rate: selecting the right discount rate is essential. It reflects the return required by shareholders and lenders, linked to the risk of achieving the projected flows. The WACC (weighted average cost of capital) is typically used, weighting both costs according to the capital structure.

Normalising EBITDA: the step that moves the most value in the mid-market

In the Spanish mid-market, with its strong family ownership, the EBITDA reported in the statutory accounts is merely a starting point that must be adjusted. The aim is for the projected flow to reflect the recurring economic potential of the business under professional, independent management. The usual adjustments are:

This normalisation is precisely the core of a quality financial due diligence (Quality of Earnings): a buyer pays not for reported EBITDA, but for normalised, sustainable EBITDA.

2) Terminal Value

Since the company's activity — and therefore its cash generation — need not end in year 5 or 10 of our projections, the value beyond the explicit period must be estimated. The Terminal Value represents the present value of all future cash flows beyond the forecast period, assuming a moderate perpetual growth rate.

• Perpetual growth range: usually conservative, often between 1% and 2%, and necessarily below the economy's long-term growth rate. If a company grew to infinity at a rate above GDP, it would eventually absorb the entire economy of its region.

This parameter deserves great care, because the Terminal Value typically represents between 60% and 80% of Enterprise Value (around 71% in standard transactions). Two further cautions:

• Consistency with GDP: for Spain, a prudent perpetual growth rate sits in the 1.5%–2.5% nominal range over the long term.
• Consistency with reinvestment: positive perpetual growth cannot be projected without reflecting the capex and working capital that sustain it. The perpetuity reinvestment rate must equal growth (g) divided by ROIC. Assuming 2% growth with zero reinvestment (capex equal to depreciation) artificially inflates value.

3) Enterprise Value and Equity Value

Finally, the projected cash flows and the terminal value are discounted to the present using the discount rate. The sum of these present values gives the total value of the firm.

• Enterprise Value (EV) vs. Equity Value: summing the present values of the projected flows and the terminal value yields the EV. To reach Equity Value, net financial debt (financial debt less cash) and other non-operating assets or liabilities are subtracted. This distinction is critical because Equity Value reflects what is attributable to shareholders after repaying net financial debt — the intrinsic value of the shares.

The discount rate (WACC) in the Spanish market: mistakes that destroy value

Setting the rate is one of the most critical and error-prone stages. A change of just 1% or 2% can dramatically alter Enterprise Value. Professor Pablo Fernández (IESE) warns that the WACC is a construct built on subjective inputs — equity risk premium, sector beta — where a minor change can shift the valuation by more than 50%. According to his surveys, the equity risk premium used by Spanish practitioners has historically ranged between 3% and 8.5%, with a recent median around 6.0%–6.4%.

In SMEs, moreover, the classic CAPM inputs must be penalised with a size and illiquidity premium (SP) reflecting smaller scale, restricted access to financing, business-plan execution risk, customer concentration and key-man risk. Omitting these premiums typically distorts the rate by 100 to 300 basis points. These are the seven most serious and frequent mistakes:

• Using the cost of debt as the discount rate, ignoring that shareholders demand more than the bank.
• Using book weights instead of market weights to weight E/V and D/V.
• Not updating the rate when the capital structure changes (e.g. when debt is projected to be repaid).
• Applying the corporate rate to projects of different risk (international expansion, new technologies).
• Using short-term risk-free rates (12-month bills) instead of the 10-year sovereign bond.
• Mixing nominal flows with real rates (or vice versa), breaching the Fisher equation. With Spanish inflation forecast at 3.0%–3.4% in 2026, nominal flows require a nominal WACC.
• Failing to distinguish the equity rate from the firm rate: discounting FCFF at Ke, or FCFE at the WACC, invalidates the net-debt calculation.

Another mistake specific to the Spanish framework is applying the tax shield without limit. Spanish law caps the deductibility of net financial expense at 30% of operating EBITDA, which in highly leveraged companies raises the real after-tax cost of debt and, with it, the WACC.

From Enterprise Value to the seller's cheque: the Equity Bridge

This is the angle that separates an academic valuation from a transactional one. The DCF delivers an Enterprise Value, but that is not the amount the seller receives. In private M&A processes, deals are struck on a cash-free, debt-free basis with an agreed normalised working-capital level. The move from EV to Equity Value is set out in the share purchase agreement (SPA) through the equity bridge:

Equity Value = EV + Cash − Financial debt − Debt-like items ± Working-capital adjustment

Negotiation concentrates on the debt-like items: liabilities that, while not visible bank debt, the buyer requires to be treated as debt and which reduce the price. The most common in Spain:

• IFRS 16 (leases): treated as debt if the lease expense has previously been added back to EBITDA; if it was not added back, deducting it would be a double penalty.
• Minority interests in consolidated groups, and non-operating assets (family-use real estate, financial investments), valued separately and added back as value for the seller.
• Factoring and reverse factoring (confirming): non-recourse factoring generates apparent liquidity whose fees should be reclassified as financial; reverse factoring that overextends supplier payment terms is usually treated as disguised financial debt.

Public-sector financing — very common in the Spanish mid-market and a recurring source of disagreement in due diligence — deserves separate mention:

A numerical example (industrial mid-market)

The gap between operating value and the final cheque is clearest with numbers:

Although the business is valued operationally at €28m, the shareholders receive a net cheque of €24.2m. The lesson: negotiating the equity bridge and the quality of the balance sheet weigh as much as the operating projections themselves. That is why the list of debt-like items and the normalised working-capital formula should be locked down in the letter of intent (LOI), not in the closing stretch.

Triangulation: the DCF is never used alone

A DCF model should not be built in isolation, but within a cross-checking framework. Buyers value on the basis of sustainable future cash flow and the return they require; the EBITDA multiple is ultimately the standardised format that packages those conclusions for comparability. The DCF is therefore always cross-checked against the multiples of listed comparables and precedent transactions. Two Spanish-market nuances:

• Control premium: private control transactions carry a premium of 20% to 40% over listed-company multiples, reflecting the value of acquiring 100% of the voting rights and capturing synergies.
• Deal structure: unlike the zero-rate era (up to 90% in cash at closing), in 2025-2026 it is common to structure 65%–75% upfront and 25%–35% deferred via earn-outs tied to future EBITDA.

Preparing the transaction also requires rigorous financial due diligence (quality of earnings, cash-flow sustainability, maintenance capex, working-capital behaviour). A full sale process coordinated by an adviser usually runs between 6 and 18 months.

Challenges and Conclusions on the DCF

Despite its strengths, the DCF is not without challenges. The accuracy of a DCF valuation depends heavily on the quality of the cash-flow projections and on choosing the right discount rate. Assumptions that are too optimistic or too pessimistic lead to flawed valuations. A balanced approach and a deep understanding of the company and its environment are therefore essential, together with sensitivity analyses that present the valuation within a reasonable range rather than as a single fixed figure.

The DCF remains the cornerstone of financial valuation for one reason: it offers a detailed, realistic view of a company's intrinsic value, incorporating both its future prospects and the associated risks. Although it demands detailed analysis and careful assumptions, when correctly applied the DCF provides a solid basis for informed investment decisions.

At Maraz Corporate Finance we are experts in business valuation. If you are considering selling your company, bringing in an investor or need a rigorous valuation to support a decision, contact our team for a preliminary analysis of your case.

Frequently Asked Questions about the DCF

What is the DCF method in business valuation?

Discounted Cash Flow (DCF) is a method that values a company as the present value of the cash flows it is expected to generate in the future, discounted at a rate reflecting its risk (usually the WACC). It is the benchmark method for estimating the intrinsic value of a business with stable, predictable flows.

What is the difference between Enterprise Value and Equity Value?

Enterprise Value (EV) is the value of the operating business, free of debt and cash. Equity Value is what shareholders actually receive: it is reached by adding cash and subtracting financial debt and debt-like liabilities. In a transaction, the bridge between the two — the equity bridge — is where much of the price negotiation concentrates.

Which discount rate is used in a DCF?

It depends on the flow: the unlevered free cash flow (FCFF) is discounted at the WACC; the flow available to shareholders (FCFE) at the cost of equity (Ke). In Spanish SMEs, the WACC usually incorporates additional size and illiquidity premiums and frequently sits in the 10%–16% range.

Why is the terminal value so important in a DCF?

Because it represents between 60% and 80% of the company's total value. A small change in the perpetual growth rate (g) or the WACC has an amplified effect on the result. That is why g must be conservative (1.5%–2.5% in Spain, always below GDP) and consistent with the reinvestment needed to sustain that growth.

When should the DCF NOT be used?

When future flows are very hard to project: early-stage or pre-revenue startups, highly cyclical businesses or companies with recurring losses. In those cases it is complemented by the Venture Capital Method, adjusted net asset value or, above all, valuation by multiples.

Does the DCF replace valuation by multiples?

No: they complement each other. The DCF provides intrinsic value based on cash generation; multiples anchor that value to what the market pays for comparable companies. A professional valuation triangulates both to build a defensible range, not a single number.

Javier de Rojas Roca de Togores

Partner– Maraz Corporate Finance