Private Equity Buyout Valuations and Discounted Cash Flow 

By | October 5, 2022

Private equity firms have been a mainstay of the mergers and acquisitions (“M&A”) industry for decades.  Private equity firms are in the business of acquiring companies and subsequently selling them, ideally at a higher price.  Those returns are then distributed to the investors of the underlying private equity fund after the private equity firm has taken its cut.  Part of the success of private equity lies in its ability to grow companies and make them more efficient.  Additionally, the heavy use of leverage can amplify the returns.  However, another key consideration is the price that private equity firms pay for those companies in the first place, which means that valuing potential corporate targets is critical. 

In my recent paper, I scrutinize the most common method used by private equity to value private companies – discounted cash flow (“DCF”).  The standard formula for DCF has been widely cited, but for those without a finance background, deciphering the formula can be entirely intractable.  It is important, though, for M&A lawyers, as well as students and experienced researchers in private equity, to appreciate the rationale for DCF and what private equity professionals take into account when valuing private company targets.  A fulsome understanding of DCF can be instructive in drafting various financial-related elements of purchase agreements and enables lawyers to better apprehend the commercial drivers of their private equity clients. 

Free Cash Flow 

The underpinning of DCF valuation is the prediction of the free cash flows of a corporate target over the lifetime of that company.  Free cash flow is the amount of annually generated cash that is free and clear of all internal and external obligations.  It represents the potential returns available to the private equity firm over the lifetime of the company, which, unless it is intended that the company will be liquidated and its assets sold, is usually presumed to be infinite.  Free cash flow can be used to pay down acquisition debt or distributed as returns to the underlying private fund.  If the private equity firm can predict the free cash flow that will be generated by the company each year, it can form a legitimate basis for valuation.  Predictions are based upon a variety of factors including the firm’s business plan for the target company and its confidence in being able to grow and improve the company’s business fundamentals.   

Discounting Free Cash Flow  

Simply predicting free cash flow for each year and aggregating it will produce an artificially high value for the company.  With the clue being in the name, DCF involves “discounting” the free cash flow predictions, since free cash flow sums received many years in the future are worth less to the private equity firm on the date of acquisition.  If the free cash flow sums had been available immediately upon acquisition, they could have been used to reduce the cost of capital to the private equity firm by partly paying down the acquisition debt (reducing future interest payments) and by partly making distributions to the private equity firm, thus reducing the total equity contribution employed (which could then be used to make returns elsewhere).  Therefore, the discount rate applied to free cash flow predictions must reflect, on a weighted basis, both the private equity firm’s cost of debt and its cost of equity between the acquisition date and the end of the year for which each free cash flow sum is predicted.  The cost of debt factored into the discount rate is simply the interest rate payable on that debt, while the cost of equity is the rate of return that the firm could have made on another investment had the equity contribution been employed elsewhere.  A common approach when determining that cost of equity is to use the minimum rate of return that the firm intends to make on the acquisition investment.  

The Onset of Fixed Growth Rate 

Conceptually, a perfect DCF valuation would be the aggregate of specific predictions of free cash flow for each year of the company’s life discounted to present-day value.  However, the further into the future, the more difficult it becomes to predict free cash flow.  Changes in economic conditions and the emergence of competitors are not easily foreseen.  Additionally, the private equity firm will be intending to exit the investment, after which it will no longer be in control and it becomes difficult to envisage how the company will subsequently perform.  Therefore, DCF valuations are split into two phases, which I label in my paper the “specific prediction phase” and the “general prediction phase”.  During the specific prediction phase, which usually runs until the year in which it is intended that exit will occur (usually two to five years post-acquisition), free cash flow is specifically predicted year on year, whereas during the general prediction phase, a fixed growth rate by which free cash flow will annually grow is presumed for the firm in perpetuity.  Absent a crystal ball, uncertainty usually leads to a conservative estimate for growth during the general prediction phase. 

The Terminal Rate 

Even if a fixed growth rate is applied during the general prediction phase, remember that the company is presumed to have an infinite life.  How can free cash flows for an infinite period of time be aggregated?  This is where the terminal value comes in.  Rather than aggregating free cash flows for each year of the general prediction phase (i.e. forever!), a lump sum, known as the “terminal value”, is deduced for the first year of the general prediction period.  That lump sum can be visualized as an endowment from which income can be produced going forward equal to the predicted free cash flow that would be generated in each impending year when applying the fixed growth rate.  In the paper, I explain further why the private equity firm’s cost of capital can be used as the notional rate of return on the lump sum endowment and, correspondingly, how the terminal value is calculated.  In a private equity context, there is further legitimacy in using terminal value as a proxy for future free cash flow, since the commencement of the general prediction period will align with when the firm is seeking an exit, and therefore, the terminal value could be envisioned to be the price that a third party may be willing to pay for the company at that stage (or the value of the company if an initial public offering were completed).  Having calculated the terminal value, do not forget to discount it!  The terminal value is deemed “received” at the start of the general prediction period, so it will be worth less to the private equity firm on the acquisition date.  Accordingly, it should be discounted in the same manner as free cash flow predictions during the specific prediction phase. 


DCF calculates company value using the company’s predicted capacity to generate freely available cash over its lifetime discounted to present-day value to compensate the private equity firm for having to pay for that future cash flow on the acquisition date, expending debt and equity costs as a result.  The discounted free cash flows during the specific prediction phase are aggregated with the discounted terminal value predicted for the general prediction phase to calculate the total valuation for a corporate target.  Financiers may regularly invoke a rather tortuous formula when discussing private equity valuations, but legal specialists should not be intimidated – when deconstructed to its constitutional elements, DCF valuations can be more coherently rationalized. 


Bobby V. Reddy is an Assistant Professor in Corporate Law at the University of Cambridge, and a former partner of Latham & Watkins LLP.  He is a fellow of the Cambridge Endowment for Research in Finance. 

This post is adapted from his paper, “Deconstructing Private Equity Buyout Valuations,” available on SSRN.  The final version of this paper is forthcoming in the Journal of Business Law. 

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