DCF (Discounted Cash Flow)

DCF (Discounted Cash Flow) is a valuation method that estimates the value of a business by projecting its future free cash flows and discounting them to the present at a rate that reflects the business’s risk and the investor’s opportunity cost of capital. In theory, DCF is the most rigorous valuation method: value equals the present value of what the business will generate, not what comparable companies trade at. In practice, in M&A of Mexican SMEs DCF is rarely the main valuation method because the inputs —projected cash flows and discount rate— are too uncertain in businesses without audited financials, institutional management, or a predictable growth track record.

How does DCF work?

DCF has three components:

1. Free cash flow (FCF) projection

   Estimate the free cash flow the business will generate each year over a projection period —typically 5 years in SME transactions. Free cash flow = EBITDA minus taxes, capital expenditure, and changes in working capital.

2. Discount rate (WACC or required return)

   The rate used to discount future flows to the present. In SME transactions it is the return required by the buyer —not a textbook WACC— because the business has no public-market comparables and the risk profile is deal-specific.

3. Terminal value

   The estimated value of the business beyond the projection period, typically calculated as a perpetuity with growth or as an exit multiple applied to year‑5 EBITDA.

DCF is one of the methods covered in business valuation.

Where r = discount rate required by the buyer

Illustrative example (specialty retail, Mexico, anonymized):

Note: Discount rate: 18% (return required by the buyer). Terminal value: 6× year‑5 EBITDA. Any change in the rate or in the projections moves the result significantly.

Why does the EBITDA multiple dominate over DCF in Mexican SME transactions?

In M&A of Mexican SMEs the EBITDA multiple method dominates for three reasons:

• Projections are unreliable

  A founder who has never prepared a formal budget cannot produce a 5‑year cash flow projection that a buyer will trust. The DCF result is only as reliable as its inputs —and in businesses without audited financials or institutional planning, those inputs are estimates on top of estimates.

• The discount rate is subjective

  In a DCF of a public company the rate is derived from market data —beta, risk‑free rate, market premium. In a Mexican SME transaction there is no market data. The buyer’s required return is a negotiation position, not a calculation. Two buyers with different returns will produce DCF values that differ 30–50% on the same projections.

• The multiple is more transparent

  Both sides understand “4× normalized EBITDA”. They can debate EBITDA normalization, the multiple, or both —but the logic is visible. A DCF hides assumptions inside a model that looks precise but is not.

Where DCF is used in Mexican SME M&A: as a sanity check on the multiple, not as the main method. A buyer may run a DCF to verify that the 4.5× multiple it is paying implies a reasonable return under its assumptions. If DCF implies 35% return and the multiple implies 18%, something in the assumptions does not add up. To compare both methods in context, see EBITDA multiple.

What are the limitations of DCF in SME businesses?

• Garbage in, garbage out

  A DCF built on optimistic projections produces an optimistic valuation. In SME transactions the seller always projects growth; the buyer always discounts it. The negotiation happens in the assumptions, not in the model.

• Terminal value dominates the result

  In most SME DCFs, 60–75% of total value comes from terminal value —the estimated value beyond year 5. A small change in terminal growth rate or exit multiple changes total value drastically. A method where most of the answer depends on a single assumption about the distant future is not a reliable anchor for negotiation.

• It does not capture concentration or dependence risk

  DCF assumes the business will generate its projected flows. It does not model the probability that the key client leaves or that revenue collapses without the founder. Those risks are captured in the discount rate —but the discount rate is a blunt tool for risks that are binary, not continuous.

• Not applicable without reliable financial history

  A business with 3 years of mixed, informal accounting and no audit trail cannot produce projections a buyer will subscribe to. DCF requires a credible historical data base that many Mexican SMEs do not have.

What do buyers and sellers ask about DCF?

Why do buyers of Mexican SMEs prefer the EBITDA multiple over DCF?

Because the multiple is based on historical normalized EBITDA —something both sides can verify— not on projected future cash flows that neither side can know with certainty. In a segment where most businesses lack audited financials and formal planning, DCF produces such a wide range of values that it is not useful as a negotiation anchor. The multiple is simpler, more transparent, and based on what the business has actually done, not what the seller projects it will do.

What is the correct discount rate for a Mexican SME?

There is no single correct rate. Buyers in Mexican SME transactions require returns of 18–30% depending on: business risk profile, customer concentration, owner dependence, sector volatility, and deal structure. A business with diversified customers, institutional management, and clean finances justifies a 20% discount rate. One with 70% customer concentration and 90% owner dependence requires 30% or more. The rate is a negotiation position as much as a calculation.

Should DCF and the EBITDA multiple give similar values?

In theory, yes —both should converge on the same intrinsic value if assumptions are consistent. In practice they diverge because DCF uses forward projections while the multiple is based on historical normalized EBITDA. A business with strong growth prospects shows a higher DCF value than the multiple implies when projections support it —that is the seller’s argument for a premium multiple. A business with declining trends shows a lower DCF value —that is the buyer’s argument for a discount.

When does it make sense to use DCF in a Mexican SME transaction?

When the business has: 3 or more years of audited or reviewed financials, a management team that operates independently of the founder, diversified revenue with low customer concentration, and a credible growth thesis backed by contracts or pipeline. Under those conditions DCF can support a premium over the historical multiple. In the typical Mexican SME transaction —owner-operated, concentrated, informal finances— DCF is only useful as a sanity check, not as the main valuation method.