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Doing just a few DCF calculations demonstrates the link between a company's cost of capital and its valuation. For large public companies (like Apple), the cost of capital tends to be somewhat stable. But for small companies, this cost can fluctuate significantly over economic and interest rate cycles. The higher a company's cost of capital, the lower its DCF valuation will be. For the smallest companies (below about $500 million in market cap), DCF technicians may add a "size premium" of 2-4% to the company's WACC to account for extra risk.

During the credit crunch of 2007 and 2008, the cost of capital for the smallest public companies soared as banks tightened lending standards. Some small public companies that could tap bank credit at 8% in 2006 suddenly had to pay 12-15% to hedge funds for increasingly scarce capital. Using simple DCF valuation, let's see what the impact of increasing WACC from 8% to 14% would be on a small public company with $10 million in annual cash flow and projected annual cash flow growth of 12% over a 10-year period.

Based on the higher cost of capital, the company is valued at $38.6 million less, representing a 26.9% decline in value.

Building a Company's Value

If you are building a small company and hope to sell it one day, DCF valuation can help you focus on what is most important - generating steady growth on the bottom line. In many small companies, it's difficult to project cash flow or earnings years into the future, and this is especially true of companies with fluctuating earnings or exposure to economic cycles. A business valuation expert is more willing to project growing cash flows or earnings over a lengthy period when the company has already demonstrated this ability.

Another lesson taught by DCF analysis is to keep your balance sheet as clean as possible by avoiding excessive loans or other forms of leverage. Awarding stock options or deferred compensation plans to a company's top executives can strengthen a company's appeal to attract quality management, but it also can create future liabilities that will increase the company's cost of capital.