What is an example of calculating discounted cash flow analysis?

Let’s say you’re looking at buying a 10% stake in a private company. It has an established business model that’s profitable and its revenue is growing at a consistent rate of 5% per year. Last year, it produced \$2 million in cash flow, so a 10% stake would’ve likely given you \$200,000 had you purchased it last year.

Here’s a simplified explanation of how DCF analysis could help you determine how much you should reasonably pay for that 10% stake:

This year, the business would give you \$210,000, assuming the company’s established 5% YoY revenue growth. Next year, \$220,500, and so on, assuming the company’s growth rate stays consistent.

Let’s also assume your target compound rate of return is 14%—that is to say, the rate of return you know you can likely achieve on other investments. This means you wouldn’t want to purchase the stake in the business unless you knew you could achieve at least that rate of return; otherwise, you’re better off investing your money elsewhere. Because of this, 14% becomes the discount rate (r) you apply to all future cash flows for the prospective investment.